Why Organizations Should Hedge

Published Date: 02 Nov 2017

INTRODUCTION:

Financial risk management means that as a practice of creating economic value in the firm by using financial tools which controlling risk exposure, especially market risk and credit risk. Financial risk management targets at which time and in what way hedging uses financial tools to control cost exposures to risk. Hedging is a financial instrument/tool uses for the purpose of managing risk in investment. Risk management is the process in which integration of identifying risk, develop plan to control it, choosing the tool and hedging the risk. The fact of being identified risk can begin with the source (originates) of problems, or with the problem itself to know the risk facing the business.

Corporate hedging is a way that corporation can protect itself against the foreign exchange rates, this is a mechanism to protect a firms from the exposure of foreign risk. The process is controlled by firm treasury officials and they work hard toward maximizing foreign income and minimizing costs. Companies attempt to hedge for the reason of foreign currency fluctuations as risks that are immediately connected to the central business operation. (www.article.economictimes.indiatimes.com).

Hedging is done to prevent market rising and falling irregularly from interfering with the business secure for investments, decrease costs of financial distress and increase debt capacity. Since currency matching reduces the probability of financial distress, it allows the firm to have more earning stability and more optimal leverage. Hedging is possible if exposure are known so the first step is to define and measure exposure, also only possible if the institution understand how effective are the instrument of hedging, forwards, futures, swaps and options.

Practice of covering exposure is designed to reduce the volatility of a firm’s profit/cash generation; this will reduce the volatility of the firm.

Exposure management is a device to reduce the variability of the firm’s profit or valuation caused by changes in interest rate and exchange rates. But there is a countervailing arguments advanced by a number of financial academics; reducing the variability of the firm’s return while leaving their expected level unchanged should have little or no effect on the value of the firm. This situation derives from the capital asset pricing model (CAPM) , the firm’s operation are viewed as being risky in the sense that they move or fail to move together with market as a whole.

OBJECTIVES OF HEDGING POLICY:

Hedging increase value of shareholders by reducing capital cost and income earned is stable.

The objective of any hedging policy should be to the organization achieving optimal risk profile that measures the benefit of protection against the costs of hedging.

A policy of hedging which is well designed reduces costs and risks. Hedging frees up resources and guide management to take into consideration on the aspects of investment in which it has a better results by reducing the exposure that are no central to the basic business.

Due to foreign exchange risk management many firms retrain from active management of their foreign exchange exposure, even though they aware that exchange rate fluctuation can affect their earning and value (www.people.stern.nyu.edu)

There are several reasons firms may choose to hedge risks, those are:-

Tax laws may benefit those firms who are risk hedgers.

Reducing the exposure among the risk may enable firms with more freedom to have fine tune their capital structure.

Investors may find the financial statement of organization that hedge against irrelevant or unrelated risks to be more useful information than organization that do not.

While a significant proportion of organization hedge against risk, some risks seem to be hedge more often than others, the two most widely hedged risks are: Exchange Rate Risk and Commodity Price Risk.

Alternative techniques for hedging risk:

When there is a decision of reducing exposure to a risks, there are different approaches can be used. Some of these are performing the same function on investment and financing decisions that every business has to make; risk exposure is determined by assets that invested in and the fund that are used to support these assets. Some have been made available by large and growing derivatives markets where futures, options and swaps can be used to manage risk exposure (www.people.stern.nyu.edu)

WHY ORGANIZATIONS SHOULD HEDGE:

A firm is confronted with interest rate, exchange rate or commodity price risk is only a necessary condition for the firm to control that risks. The sufficient condition is that the exposure management raise the value of the firm:

It can be written as:-

E (NCF) = Expected Net Future Cash Flows

V = the value of the firm

K = Cost of Capital

If the firm’s value is to increase, it must do so as a result of either an increase in expected net cash flows or decrease in the discount rate.

The risks are usually hedged in an exposure management policy, currency risk, interest rate risk and commodity price risk, all of these may be interpreted from the stand point of portfolio theory. It follows that active management of these risks should have no effect on the firm’s cost of capital. Risk management should not increase the expected value of the firm through reduction in the discount rate.

Exposure management can only be expected to increase the value of the firm through an increase the expected net cash flows if a company held by well diversified investors.

Avoidance of financial distress and reduction in the present value of taxes paid are both potential sources of such value creation via hedging, into financial difficulty and bearing the consequent cost of distress. The arguments for hedging are:

Hedging reduces financial distress, if company is in this situation, shareholders will be discouraged to have excess equity for financial resources, and thus why the part of the gain worth will go to the suppliers. By decreasing the volatility of future cash flows which is expected, using of hedging strategy decrease or completely removed financial distress and raise worth.

Capacity of borrowing is increasing by hedging when the volatility of company value is reduced. More suppliers are ready to give loan to the company. In spite of the fact that, additional loan financing generate value only if this is the means of funding project with positive Net Present Value, hedging raise the capacity to the company, because of management risk efficiency.

Asymmetric information is diluted by hedging, when organization experiences volatility in earning, owners of shares in company have no knowledge if this volatility is caused by financial exposure that could be hedged or due to ineffectiveness of managerial decision making. Means that owners of shares of the company and top management do not sharing the information and that organization have enough information about financial risks that could be hedge, this will dilutes asymmetric information.

Hedging anticipates risk aversion. Increasing volatility of organization value affects the organization’s capacity to carry out business as usual in many areas including business loan, employee retaining and customer satisfaction. Managers look forward to their risk aversion by uses of hedging for reducing volatility (www.voices.yahoo.com).

According to Mayers and Smith (1982), Smith and Stulz (1985) and Smith (1999) shows that in the presence of a convex tax function, hedging reduces the variability of pre tax firm values and reduces the expected corporate tax liability, Therefore reducing the volatility of taxable income generates greater firm value if the firm faces a convex tax function.

There is evident impact upon profit and cash generation of the firm.

Below are the evidence from recent research articles into hedging and the value of the firm:-

The argument about hedging as a way to reduce underinvestment risk is adopted as the starting point for the analysis of the Southwest’s case in the subsequent sections, although of the probability of distress can be pointed out as another value creating of probability of distress, (Particularly for Airlines), the investment argument fits very well the case of Southwest, it is also more suitable for a quantitative analysis. According to the ATA the global airline industry hedged 50% on average of its fuel needs in 2008 (Marquez 2009). In the United States, Southwest hedging percentage used to be as high as 95% until and the Dallas based carrier has been admired for the success of its hedging program (the percentage is now significantly lower).

Airlines’ investment opportunities can be protected by hedging jet fuel risk, analysis focused on the airline industry reduction of the underinvestment risk as the primary source of value creation from hedging. Morgan Stanley analyst William Greene in July 2008 (Moore 2008) called Southwest "an oil play". Greene stressed the fact that in the middle of the oil price crisis of 2008, Southwest’s management announced plans to sustain growth. According to the analyst this is the evidence of how hedging is used at Southwest as a durable competitive advantage (www.kellogg.northwestern.edu).

There is evidence of significant gain in hedging from Brazil; the impact of company’s hedging activities on firm value for a sample of non financial firms from 1996 to 2005. The results show that hedging activities do increase the firm value. The study analyzed the impact of the firm’s hedging policy on their market value for a sample of Brazilian non financial companies listed in the Sao Paulo Stock Exchange from 1996 to 2005, results indicate that the adoption of hedging policy adds value to the firm, also indicate that the positive impact of using derivatives is independent of the econometric method and period analyzed. The result is also robust with relation to the inclusion to the hedging policy (www.cass.city.ac.uk).

WHY ORGANIZATION SHOULD NOT HEDGE:

According to Purchasing Power Parity (PPP); movement in exchange rate offset price level changes. If Purchasing Power Parity were to hold immutably and with no time lags, there would, so the argument goes, be no such thing as exposure to exchange rate risk and consequently there is no need to hedge.

The CAPM has some guns arrayed against hedging according to CAPM the essential aspect of risk which matters is systematic risk, if exchange rate risk and interest rate risk are considered to unsystematic risk they can be diversified away by investors in the process of constructing their own portfolio. On other hand if currency risk and interest rate risk are systematic and if forward exchange and interest hedge contracts is to move along the security market line, if this is so, then there is "no addition to the value of firm"

Being in financial distress increase the lenders undertake the downside risk. These situations might discourage shareholders from hedging.

If investors are having enough resources with the ability to do a particular work and great skill to hedge by themselves, they should do such kind of strategy. If organization is doing better and shareholders are well diversified, most of the time the practice of hedging is not needed (www.voices.yahoo.com).

"As Adler (1982) put it "In the absence imperfection like transaction costs and default risk, the value of forward contract would be zero at the instant at which it was initiated. In the reality there are transaction cost the bid/offer spread for one, so in the real world according to the argument, companies could be said to destroy value by entering into forward contract.

Another argument against corporate hedging is concern the desires of the shareholder for corporate risk. For example; take a company like BP, although a British company with a substantial sterling base of shareholders. BP income flows are essentially in dollars since oil is priced in dollars. If the shareholders’ consumption patterns were dollar based or if shareholders wanted to take on dollar risk, it might make sense for BP not to hedge its dollar exposure at all. Of course, companies are unable to know intimately their shareholder’s consumption patterns or desire for risk and this line of reasoning leads to the conclusion that company might hedge its exposure. But the observation of this argument contends that, should companies leave themselves without hedging and communicate the nature of their exposure to shareholders. It would then be up to investors to make their own decisions, about whether they wished to take on the company’s risk by investing (Page 179 – Multinational Finance, Adrian Buckley).

There is evidence from the Gold Mining Industry, Jin and Jorion (2006) study the hedging activities of 44 North American gold mining firms from 1990 to 2000 and evaluate their impact on equity exposure and firm value. Their result offers further evidence that hedging commodity price does not automatically increase firm value. This is consistent with Jin and Jorian (2006).

Jin and Jorian examines the relationship between gold hedging and firm value and show that gold hedging reduces mining firm’s stock exposures to gold prices. However, contrary to the argument that hedging increases firm value and they do not find a positive association between hedging and firm value, as measured by Tobin’s Q ratio. In fact, the relationship appears negative. Jin and Jorian (2006) find no association between derivatives hedging and firm value for a sample of oil and gas producers. Within the gold industry, these results support the conclusions in Tufano (1996), who finds little empirical support for theories claiming that hedging appears from firm value maximization motives. Instead, he shows that hedging appears to be driven primarily by managerial risk aversion. If so, there should be no association between hedging and firm value, which is confirmed by their empirical analysis over an extended sample period ( www.myweb.Imu.edu).

CONCLUSION:

Hedging is a function of options, probably hedging strategies can be useful for large institutions, small firms or even the individual investor can benefit. Hedging whether in portfolio or business is about eliminating, decreasing or transferring risk.

In order to make hedging program effective the corporate risk manager should determine the company’s risks willing to bear and those wishes to transform by hedging. The target of hedging program should be assist organization to succeed the optimal risk profile that ensuring stability the benefits of protection against the hedging costs.

Corporate finance theory models as the real world; makes an effort to achieve hedging on the added value in a definite way.

Although by hedging risks makes sense to decrease the volatility of value or the difference of the expected future cash flows in the derivatives markets, theories are not conclusive. These principles should be considered when making evaluation on the added value of hedging. Therefore, managers of finance and Directors should not only know theory, but also its limitation (www.voices.yahoo.com).