To answer the question “what is hedging?” in the general sense, we can imagine a company entering into a transaction whose sensitivity to movements in financial prices offsets the sensitivity of their core business to such changes. Hedging objectives vary widely from firm to firm, even though it appears to be a fairly standard problem.
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. 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, all with the objective of answering the question: what is hedging?
What is Hedging and Why Do Companies Do It?
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 an 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 favor of hedging.
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.
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 movements in these prices do not pejoratively affect it. 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 of the shareholders. Setting hedging policy is a strategic decision, the success or failure of which can make or break a firm.
Consider the example of a Canadian pulp-and-paper company, 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 that 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, 1.05 and the prevailing one-month forward outright rate at which they could hedge themselves 1.0510.
If they 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 1.0510.
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 1.10, then they have foregone 490,000 Canadian dollars. This is their opportunity loss.
Are there instruments that address both certainty and opportunity? Fortunately, there are. They are called derivatives and 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 behavior of a financial price.
For example, the price of a foreign exchange option on the Canadian dollar on 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 of 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 call 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 1.0310 for a premium from one of its financial institution counter-parties. 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.
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 a 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. What is hedging? For one, 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.
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.
Hedging Objectives 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.
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.
The Hedging Instruments Available to the Corporate Treasurer
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.
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.
Answering the Question: What is Hedging?
What is hedging? Hedging is a technique for managing investment risk in derivatives markets. In relation to this idea, 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.
- Article by Chand Sooran, Point Frederick Capital Management, LLC