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.
What is Hedging?
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.
These may include foreign exchange rates, interest rates, commodity prices and equity prices. The effect of changes in these prices on reported earnings can be overwhelming, so companies will seek out transactions whose sensitivity to movements in financial prices offsets the sensitivity of their core business to such changes, or hedging.
The most sophisticated players in this field recognize that a business’ financial risks present a powerful opportunity to add to their bottom line while shielding the firm from the negative effects of those movements.
Why Do Companies Do It?
Companies attempt to hedge price changes because those fluctuations are risks peripheral to the central business in which they operate.
An investor will buy the stock of a pulp-and-paper company to benefit from that company’s management of a pulp-and-paper business, not to take advantage of a falling Canadian dollar because she knows the company exports over 75 per cent of its product to overseas markets.
Hedging can also be used to improve or maintain competitiveness. Companies don’t exist in isolation; they compete with other domestic companies in their sector as well as globally.
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.
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.
Most importantly, hedging is contingent on the preferences of the firm’s shareholders when it comes to taking on anything that appears to be financial price risk.
It’s easy to imagine two companies operating in the same sector with the same exposure to fluctuations in financial prices but with completely different policies, simply because of the differences in their shareholders’ attitude towards risk.
The Hedging Problem
The core issue when trying to decide on a hedging policy is striking a balance between uncertainty and the risk of opportunity loss. Setting hedging policy is a strategic decision whose success or failure can make or break a firm.
Consider a Canadian pulp-and-paper company that sells 75 per cent of its product in U.S. dollars to customers all over the world.
The U.S. dollar is called the “price of determination” because all sales of pulp-and-paper are denominated in U.S. dollars.
The company closes a deal for US$10 million worth of product and knows that in one month, it will receive payment into its U.S. dollar accounts.
Since it’s bound to have receivables in U.S. dollars, the company is exposed to changes in the rate of exchange for the Canadian dollar against the U.S. dollar.
As a Canadian company, it will have to repatriate those U.S. dollars at some point because it has decided that foreign exchange risk is not something it’s prepared to carry because that risk is peripheral to the core business.
If the company doesn’t hedge the transaction in any way, it won’t know with any certainty at what rate of exchange it’ll be able to exchange the US$10 million when it’ delivered. It could be better or worse than the rate prevailing currently for exchange of that amount in a month’s time.
For argument’s sake, let’s call the prevailing spot rate 1.05 and the prevailing one-month forward outright rate at which the company could hedge itself 1.0510.
If the company enters into a forward contract in which it will have to buy Canadian dollars and sell U.S. dollars for delivery on the same date as the delivery date on its pulp-and-paper contract, it has removed this uncertainty. The company knows without any question at what rate this exchange will be: 1.0510.
But, that company has 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 it has foregone 490,000 Canadian dollars. This is the opportunity loss.
Fortunately, there are instruments that address both certainty and opportunity – derivatives and derivative products.
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 the company had the right, but not the obligation, to buy Canadian dollars and sell U.S. dollars at a pre-set strike price will vary on a day-to-day basis with the movement of the Canadian dollar/U.S. 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. That reduces its certainty about the rate at which it will repatriate the U.S. dollars but it also limits the worst case in exchange, allowing the company to enjoy potential opportunity gains.
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 trade-off between uncertainty and opportunity.
The key to hedging is to decide which of these solutions to choose. But as we have seen, hedging is not just about putting on a forward contract – it’s about making the best possible decision, considering the firm’s level of sophistication, its systems and the preferences of its shareholders.
Hedging Instruments Available to the Corporate Treasurer
The decision around which instrument to use ultimately falls to the corporate treasurer.
A treasurer’s ability to operate within the context of the shareholder-delineated limits and choose the optimal hedging structure for a particular exposure and economic environment will differentiate a mediocre one from one who is excellent.
Not every structure will work well in every environment, so the corporate treasury will have to tailor the exposure using derivatives to manage the preferences and the view of the senior management and board of directors.
Exposure to Financial Price Risk
It’s important to measure and keep daily tabs on a firm’s potential liability from financial price risk. Financial institutions whose core business revolves around managing and accepting financial price risk have whole departments devoted to the independent measurement and quantification of their exposures.
There are three types of risk for every particular financial price to which a firm is will be exposed.
Transactional risks, which reflect the negative impact of fluctuations in financial prices on the cash flows that come from purchases or sales. This is the kind of risk described in the example of the pulp-and-paper company and its US$10 million contract. Its funding problem can also be described as a transactional risk: How does the company borrow money? How does it hedge the value of a loan once it’s 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.
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 and they must know the extent of risk management at these companies.
They also need to be able to distinguish between good risk management programs and bad ones.
Without this knowledge, they may be in for some ugly surprises.