(Adapted from an article published by Bank of Montreal)
THE HEDGING DECISION
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.
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.
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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Copyright ©2001 Ian Giddy. All rights reserved.