1. Effect of hedging on cash holdings Corporations care for liquidity buffers to smooth cash flow shocks in adverse market conditions. Especially, the cash flows of electric utilities are heavily impacted by seasonal weather conditions: for example, in a hotter-than-usual summer, electricity demand boosts the earning of electric utilities (e.g., everybody turns on their air conditioners), whereas in a cooler-than-usual summer, electric utilities may suffer from poor earnings. The exposure to such weather risk depends on where each electric utility is located: utilities lo cated in stable weather regions (low weather volatility) may not face much cash flow uncertainty due to weather conditions, whereas tho se located in volatile weather regions (high weather volatility) may face great cash flow uncertainty due to weather conditions In 1997, weather derivatives were introduced for firms to hedge such weather risk. That is, firms are able to buy weather derivative contracts that pay when seasonal weather is milder than usua 30 25 10 High Weather Volatility Low Weather Volatility 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Based on the plot above, whatis the net effect of weather derivatives on cash holdings of electric utilities (i.e., how much does the availability of weather derivatives increases or decreases cash holdings divided by assets)? Describe what method you used, and explain why it measures the net impact of weather derivatives on cash holdings divided by assets. Assume that lines of credit are not available, and cash holdings are the only means to secure liquidity reserves 1-1. In this case, control group is firms with (A) weather volatility, and treatment group is firms with (B) weather volatility. Choose the correct words (high or low) for (A) and (B). (A) 1-2. Net effect of weather derivatives on cash holdings divided by assets: The availability of weather derivatives increases the cash holdings divided by assets by 2. Reconsider the case of strategic default covered in class except let's assume 20% bankruptcy cost (note: in class, we considered 50% bankruptcy cost). That is, Assume 20% of the cash flow (revenue) is lost upon bankruptcy (i.e., when debtholders control the firm). Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better than firing. Upon renegotiation debt and equity holders have equal bargaining power. At what company cash flow does strategic default start to occur
