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THE HEDGING DECISION
In today’s world of globalization, all multi-national
corporations are exposed to complex foreign exchange regulations, which
affect their operations and impact their financial statements. It is
therefore critical for every multi-national corporation to identify and
measure its currency risks in order to eliminate – or, at least, reduce – the
impact caused by them.
The issue of whether or not to
hedge risk continues to baffle many corporations. At the heart of the
confusion are misconceptions about risk, concerns about the cost of hedging,
and fears about reporting a loss on derivative transactions. A lack of
familiarity with hedging tools and strategies compounds this confusion.
Corporate risk managers also face the difficult challenge of getting hedging
tools (i.e., derivatives) approved by the company's board of directors. The
purpose of this newsletter is to clarify both some of the basic
misconceptions surrounding the issue of risk as well as the tools and
strategies used to manage it. "Derivations" is part of our
commitment to work with you to create financial solutions.
THE CHALLENGE
An effective hedging program does
not attempt to eliminate all risk. Rather, it attempts to transform
unacceptable risks into an acceptable form. The key challenge for the
corporate risk manager is to determine the risks the company is willing to
bear and the ones it wishes to transform by hedging. The goal of any hedging
program should be to help the corporation achieve the optimal risk profile
that balances the benefits of protection against the costs of hedging.
This article will outline seven
steps designed to help risk managers determine whether or not their companies
stand to benefit from a hedging program.
STEP 1: IDENTIFY THE RISKS
Before management can begin to
make any decisions about hedging, it must first identify all of the risks to
which the corporation is exposed. These risks will generally fall into two
categories: operating risk and financial risk. For most non-financial organizations,
operating risk is the risk associated with manufacturing and marketing
activities. A computer manufacturer, for example, is exposed to the operating
risk that a competitor will introduce a technologically superior product
which takes market share away from its leading model. In general, operating
risks cannot be hedged because they are not traded.
The second type of risk, financial
risk, is the risk a corporation faces due to its exposure to market factors
such as interest rates, foreign exchange rates and commodity and stock
prices. Financial risks, for the most part, can be hedged due to the
existence of large, efficient markets through which these risks can be
transferred.
In determining which risks to
hedge, the risk manager needs to distinguish between the risks the company is
paid to take and the ones it is not. Most companies will find they are
rewarded for taking risks associated with their primary business activities
such as product development, manufacturing and marketing. For example, a
computer manufacturer will be rewarded (i.e., its stock price will
appreciate) if it develops a technologically superior product or for
implementing a successful marketing strategy.
Most corporations, however, will
find they are not rewarded for taking risks which are not central to their
basic business (i.e., interest rate, exchange rate, and commodity price
risk). The computer manufacturer in the previous example is unlikely to see
its stock price appreciate just because it made a successful bet on the
dollar/yen exchange rate.
Another critical factor to
consider when determining which risks to hedge is the materiality of the
potential loss that might occur if the exposure is not hedged. As noted
previously, a corporation's optimal risk profile balances the benefits of
protection against the costs of hedging. Unless the potential loss is
material (i.e., large enough to severely impact the corporation's earnings)
the benefits of hedging may not outweigh the costs, and the corporation may
be better off not hedging.
STEP 2: DISTINGUISH BETWEEN
HEDGING AND SPECULATING
One reason corporate risk managers
are sometimes reluctant to hedge is because they associate the use of hedging
tools with speculation. They believe hedging with derivatives introduces
additional risk. In reality, the opposite is true. A properly constructed
hedge always lowers risk. It is by choosing not to hedge that managers
regularly expose their companies to additional risks.
Financial risks - regardless of
whether or not they are managed - exist in every business. The manager who
opts not to hedge is betting that the markets will either remain static or
move in his favor. For example, a U.S. computer manufacturer with French
franc receivables that decides to not hedge its exposure to the French franc
is speculating that the value of the French franc relative to the U.S. dollar
will either remain stable or appreciate. In the process, the manufacturer is
leaving itself exposed to the risk that the French franc will depreciate relative
to the U.S. dollar and hurt the company's revenues.
A reason some managers choose not
to hedge, thereby exposing their companies to additional risk, is that not
hedging often goes unnoticed by the company's board of directors. Conversely,
hedging strategies designed to reduce risk often receive a great deal of
scrutiny. Corporate risk managers who wish to use hedging techniques to
improve their company's risk profile must educate their board of directors
about the risks the company is naturally exposed to when it does not
hedge.
STEP 3: EVALUATE THE COSTS OF
HEDGING IN LIGHT OF THE COSTS OF NOT HEDGING
The cost of hedging can sometimes
make risk managers reluctant to hedge. Admittedly, some hedging strategies do
cost money. But consider the alternative. To accurately evaluate the cost of
hedging, the risk manager must consider it in light of the implicit cost of
not hedging. In most cases, this implicit cost is the potential loss the
company stands to suffer if market factors, such as interest rates or
exchange rates, move in an adverse direction. In such cases the cost of
hedging must be evaluated in the same manner as the cost of an insurance
policy, that is, relative to the potential loss.
In other cases, derivative
transactions are substitutes for implementing a financing strategy using a
traditional method. For example, a corporation may combine a floating-rate
bank borrowing with a floating-to-fixed-rate swap as an alternative to
issuing fixed-rate debt. Similarly, a manufacturer may combine the spot
purchase of a commodity with a floating-to-fixed swap instead of buying the
commodity and storing it. In most cases where derivative strategies are used
as substitutes for traditional transactions, it is because they are cheaper.
Derivatives tend to be cheaper because of the lower transaction costs that
exist in highly liquid forward and options markets.
STEP 4: USE THE RIGHT MEASURING
STICK TO EVALUATE HEDGE PERFORMANCE
Another reason for not hedging
often cited by corporate risk managers is the fear of reporting a loss on a
derivative transaction. This fear reflects widespread confusion over the
proper benchmark to use in evaluating the performance of a hedge. The key to
properly evaluating the performance of all derivative transactions, including
hedges, lies in establishing appropriate goals at the onset.
As noted previously, many
derivative transactions are substitutes for traditional transactions. A
fixed-rate swap, for example, is a substitute for the issuance of a
fixed-rate bond. Regardless of market conditions, the swap's cash flows will
mirror the bond's. Thus, any money lost on the swap would have been lost if
the corporation had issued a bond instead. Only if the swap's performance is
evaluated in light of management's original objective (i.e., to duplicate the
cash flows of the bond) will it become clear whether or not the swap was
successful.
STEP 5: DON'T BASE YOUR HEDGE
PROGRAM ON YOUR MARKET VIEW
Many corporate risk managers
attempt to construct hedges on the basis of their outlook for interest rates,
exchange rates or some other market factor. However, the best hedging
decisions are made when risk managers acknowledge that market movements are
unpredictable. A hedge should always seek to minimize risk. It should not
represent a gamble on the direction of market prices.
STEP 6: UNDERSTAND YOUR HEDGING
TOOLS
A final factor that deters many
corporate risk managers from hedging is a lack of familiarity with derivative
products. Some managers view derivatives as instruments that are too complex
to understand. The fact is that most derivative solutions are constructed
from two basic instruments: forwards and options, which comprise the
following basic building blocks:
Forwards Options
- Swaps -
Caps
- Futures - Floors
-
FRAs - Puts
- Locks -
Calls
- Swaptions
The manager who understands these
will be able to understand more complex structures which are simply
combinations of the two basic instruments.
STEP 7: ESTABLISH A SYSTEM OF
CONTROLS
As is true of all other financial
activities, a hedging program requires a system of internal policies,
procedures and controls to ensure that it is used properly. The system, often
documented in a hedging policy, establishes, among other things, the names of
the managers who are authorized to enter into hedges; the managers who must
approve trades; and the managers who must receive trade confirmations. The
hedging policy may also define the purposes for which hedges can and cannot
be used. For example, it might state that the corporation uses hedges to
reduce risk, but it does not enter into hedges for trading purposes. It may
also set limits on the notional value of hedges that may be outstanding at
any one time. A clearly defined hedging policy helps to ensure that top
management and the company's board of directors are aware of the hedging
activities used by the corporation's risk managers and that all risks are
properly accounted for and managed.
CONCLUSION
A well-designed hedging program reduces
both risks and costs. Hedging frees up resources and allows management to
focus on the aspects of the business in which it has a competitive advantage
by minimizing the risks that are not central to the basic business.
Ultimately, hedging increases shareholder value by reducing the cost of
capital and stabilizing earnings.
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