Corporations in which individual investors place their money have exposure
to fluctuations in all kinds of financial prices, as a natural by-product of
their operations. Financial prices include foreign exchange rates, interest
rates, commodity prices and equity prices. The effect of changes in these
prices on reported earnings can be overwhelming. Often, you will hear companies
say in their financial statements that their income was reduced by falling
commodity prices or that they enjoyed a windfall gain in profit attributable to
the decline of the Canadian dollar.
This article will give a brief overview of the different ways in which firms
approach this financial price risk and it will introduce the rationale for
using derivative products. While there has been a great deal of negative
attention paid to derivatives in the mainstream press, the opportunities they
provide make derivatives a necessary part of the future of any corporation.
Future articles in this series will identify the benefits and drawbacks of
individual derivatives structures and explain some of the breakdowns in the
application of derivatives by corporate end-users.
One reason why companies attempt to hedge these price changes is because
they are risks that are peripheral to the central business in which they
operate. For example, an investor buys the stock of a pulp-and-paper company in
order to gain from its management of a pulp-and-paper business. She does not
buy the stock in order to take advantage of a falling Canadian dollar, knowing
that the company exports over 75% of its product to overseas markets. This is
the insurance argument in favour of hedging. Similarly, companies are expected
to take out insurance against their exposure to the effects of theft or fire.
By hedging, in the general sense, we can imagine the company entering into a
transaction whose sensitivity to movements in financial prices offsets the
sensitivity of their core business to such changes. As we shall see in this
article and the ones that follow, hedging is not a simple exercise nor is it a
concept that is easy to pin down. Hedging objectives vary widely from firm to
firm, even though it appears to be a fairly standard problem, on the face of
it. And the spectrum of hedging instruments available to the corporate
Treasurer is becoming more complex every day.
Another reason for hedging the exposure of the firm to its financial price
risk is to improve or maintain the competitiveness of the firm. Companies do
not exist in isolation. They compete with other domestic companies in their
sector and with companies located in other countries that produce similar goods
for sale in the global marketplace. Again, a pulp-and-paper company based in
Canada has competitors located across the country and in any other country with
significant pulp-and-paper industries, such as the Scandinavian countries.
Companies that are the most sophisticated in this field recognize that the
financial risks that are produced by their businesses present a powerful
opportunity to add to their bottom line while prudently positioning the firm so
that it is not pejoratively affected by movements in these prices. This level
of sophistication depends on the firm's experience, personnel and management
approach. It will also depend on their competitors. If there are five companies
in a particular sector and three of them engage in a comprehensive financial
risk management program, then that places substantial pressure on the more
passive companies to become more advanced in risk management or face the
possibility of being priced out of some important markets. Firms that have good
risk management programs can use this stability to reduce their cost of funding
or to lower their prices in markets that are deemed to be strategic and
essential to the future progress of their companies.
Most importantly, hedging is contingent on the preferences of the firm's
shareholders. There are companies whose shareholders refuse to take anything
that appears to be financial price risk while there are other companies whose
shareholders have a more worldly view of such things. It is easy to imagine two
companies operating in the same sector with the same exposure to fluctuations
in financial prices that conduct completely different policy, purely by virtue
of the differences in their shareholders' attitude towards risk.
The hedging problem
The core problem when deciding upon a hedging policy is to strike a balance
between uncertainty and the risk of opportunity loss. It is in the
establishment of balance that we must consider the risk aversion, the
preferences, of the shareholders. Make no mistake about it. Setting hedging
policy is a strategic decision, the success or failure of which can make or
break a firm.
Consider the example of the Canadian pulp-and-paper company from before, 75%
of whose product is sold in US dollars to customers located all over the world.
The US dollar here is called the price of determination because all sales of
pulp-and-paper are denominated in US dollars.
They close a deal for US$10 million worth of product and they know that in
one month's time they will receive payment into their US dollar accounts.
However, they understand that from the inception of the contract which binds
them to have receivables in US dollars in one month's time they are exposed to
changes in the rate of exchange for the Canadian dollar against the US dollar.
Immediately, they are faced with a problem. As a Canadian company, they will
have to repatriate those US dollars at some point because they have decided
that foreign exchange risk is not something that they are prepared to carry as
it is deemed it to be peripheral to their core business.
The problem has two dimensions: uncertainty and opportunity.
If they do not hedge the transaction in any way, they do not know with any
certainty at what rate of exchange they can exchange the US$10 million when it
is delivered. It could be at a better rate or at a worse rate than the rate
prevailing currently for exchange of that amount in one month's time.
Let's call the prevailing spot rate, for argument's sake, 1.5300 and the
prevailing one month forward outright rate at which they could hedge themselves
1.5310.
If they do enter into a forward contract in which they obligate themselves
to buy Canadian dollars and sell US dollars for delivery on the same date as
the delivery date on their pulp-and-paper contract, they have removed this
uncertainty. They know without any question at what rate this exchange will be.
It will be 1.5310.
But, they have now taken on infinite risk of opportunity loss. If the
Canadian dollar weakens because of some unforeseen event and in one month's
time the prevailing spot rate turns out to be 1.5600, then they have foregone
290,000 Canadian dollars. This is their opportunity loss.
Are there instruments that address both certainty and opportunity loss?
Fortunately, there are. They are called derivatives or derivative products.
Most financial institutions make markets in a panoply of risk management
solutions involving derivative products. Some of them come as stand-alone
solutions and others are presented as packages or combinations.
A derivative product is a financial instrument whose price depends
indirectly on the behaviour of a financial price.
For example, the price of a foreign exchange option on the Canadian dollar
in which our company had the right but not the obligation to buy Canadian
dollars and sell US dollars at a pre-set strike price will vary on a day-to-day
basis with the movement in the Canadian dollar/US dollar exchange rate. If the
Canadian dollar gets stronger, the Canadian dollar call becomes more valuable.
If the Canadian dollar gets weaker, the Canadian dollar becomes less valuable.
Instead of entering into a forward contract to buy Canadian dollars, the
pulp-and-paper company could purchase a Canadian dollar call struck at 1.5310
for a premium from one of its financial institution counterparties. Doing so
reduces their certainty about the rate at which they will repatriate the US
dollars but it limits their worst case in exchange for allowing them to enjoy
potential opportunity gains, again conditioned by the premium they have paid.
Derivatives just like any other economic mechanism are best thought of in
terms of tradeoffs. The tradeoffs here are between uncertainty and opportunity
loss.
However, a Canadian dollar call is only one of the possible risk management
solutions to this problem. There are dozens of possible instruments, each of
which has a differing tradeoff between uncertainty and opportunity loss, that
the pulp-and-paper company could use to manage this exposure to changes in the
exchange rate.
The key to hedging is to decide which of these solutions to choose. Hedging
is not just about putting on a forward contract. Hedging is about making the
best possible decision, integrating the firm's level of sophistication, systems
and the preferences of their shareholders.
Future articles will discuss in depth the nature of some of these
alternative solutions and the ways in which firms approach these other
instruments.
Hedging objectives
The final part of this article will introduce briefly the notion of hedging
objectives. Each of these will be discussed in articles to follow.
Earlier, we noted that a hedge is a financial instrument whose sensitivity
to a particular financial price offsets the sensitivity of the firm's core
business to that price. Straightaway, we can see that there are a number of
issues that present themselves.
First, what is the hedging objective of the firm?
Some of the best-articulated hedging programs in the corporate world will
choose the reduction in the variability of corporate income as an appropriate
target. This is consistent with the notion that an investor purchases the stock
of the company in order to take advantage of their core business expertise.
Other companies just believe that engaging in a forward outright transaction
to hedge each of their cross-border cash flows in foreign exchange is
sufficient to deem themselves hedged. Yet, they are exposing their companies to
untold potential opportunity losses. And this could impact their relative
performance pejoratively.
Second, what is the firm's exposure to financial price risk?
It is important to measure and to have on a daily basis some notion of the
firm's potential liability from financial price risk. Financial institutions
whose core business is the management and acceptance of financial price risk
have whole departments devoted to the independent measurement and
quantification of their exposures. It is no less critical for a company with
billions of dollars of internationally driven revenue to do so.
There are three types of risk for every particular financial price to which
the firm is exposed.
Transactional risks reflect the pejorative impact of fluctuations in
financial prices on the cash flows that come from purchases or sales. This is
the kind of risk we described in our example of the pulp-and-paper company
concerned about their US$10 million contract. Or, we could describe the funding
problem of the company as a transactional risk. How do they borrow money? How
do they hedge the value of a loan they have taken once it is on the books?
Translation risks describe the changes in the value of a foreign asset due
to changes in financial prices, such as the foreign exchange rate.
Economic exposure refers to the impact of fluctuations in financial prices
on the core business of the firm. If developing markets economies devalue
sharply while retaining their high technology manufacturing infrastructure,
what effect will this have on an Ottawa-based chip manufacturer that only has
sales in Canada? If it means that these countries will flood the market with
cheap chips in a desperate effort to obtain hard currency, it could mean that
the domestic manufacturer is in serious jeopardy.
Third, what are the various hedging instruments available to the
corporate Treasurer and how do they behave in different pricing
environments?
When is it best to use which instrument is the question the corporate
Treasurer must answer. The difference between a mediocre corporate Treasury and
an excellent one is their ability to operate within the context of their
shareholder-delineated limits and choose the optimal hedging structure for a
particular exposure and economic environment. Not every structure will work
well in every environment. The corporate Treasury should be able to tailor the
exposure using derivatives so that it fits the preferences and the view of the
senior management and the board of directors.
Importance
It may appear that companies in which individual investors place money do
not have exposures to financial prices. After reading this article, the reader
should have some notion of how dangerous a misconception that can be.
The single most important point to take away from this material is that
financial risk management is critical to the survival of any non-financial
corporation. Investors who have real money at risk must understand the
exposures facing the firms in which they invest, they must know the extent of
risk management at these companies and they must be able to distinguish between
good risk management programs and bad ones. Without this knowledge, they may be
in for some ugly surprises.
Article by Chand Sooran, Principal, Victory Risk Management Consulting Inc. |