Corporate Hedging as an Important Aspect in Companies - Essay Example

Introduction According to 1998 Wharton survey of financial risk management by US non-financial firms conducted by Bodnar et al (1998) more than 50% of firms used derivatives in 1998 compared to 41% in 1995 and 35% in 1995. Corporate Hedging is an important aspect and of today’s multinational companies as prediction of revenue and incomes become very difficult for companies in the face of eccentric behaviors of markets where hedging is lacking. Corporate hedging can be defined as a decrease in reliance between erratic future corporate profits and random market prices. Hence, it is the policies based on increased exposure of firm to price instability, resulting from future price knowledge. Corporate Hedging is done by multinational companies a lot, and the trend is being picked up speedily Motivation factors of multinational firms for corporate hedging seem are facilitation of internal contracting, competitive pricing concerns, and informational asymmetries. Moreover corporate hedging depends upon accounting treatment, derivative market liquidity, recent hedging outcomes, foreign exchange volatility, technical factors, and exposure volatility. What we need to understand is the reason for the multinational firms to take up corporate hedging. There are opportunities like increased leverage and tax benefits that are the motivating factors behind corporate hedging. The multinational companies opt for the hedging process simply because of the risk factor. More correctly it does not take away the risk rather the unacceptable risks are converted into acceptable risks. Many companies remain confused towards making the decision whether they should hedge or not hedge. The factors that hinder their decision making is the doubt about the risks, the cost of the hedging process itself, fear of reporting loss on derivative transactions. Also adding to all this confusion is the lack of strategies and also the un- familiarization with hedging tools. Then is the role of the corporate risk managers. They must determine the risks the company is willing to take and also the ones that the company wants to get away with through hedging. The fundamental principle behind corporate hedging is its hindrance against losses that multinational companies may face in difficult situations. Like for example the losses that incurred many IT companies by the year 1997 when there was depreciation of dollar. More commonly we can explain hedging functions in a similar manner as the hedges that protect the garden from stray dogs. The goal behind any hedging decision by a company is to maintain an optimal risk profile that balances the benefits of protection against costs of hedging. Mostly companies that were surveyed used derivatives to reduce risk1. The benefits of risk reduction for an optimally levered firm are a direct result of increased leverage and the resulting tax benefits. These two factors combined together form a strong empirical support for the explanation of corporate hedging. Then again there are the stake holders which could be employees, customers, and suppliers that cannot be modified and demand expensive terms in contracts with risky firms.2 There also is the Tax Motivating factor3. The firms face greater losses than gains due to delayed time limits and loss deductibility on carry backs and forwards. Precipitating this is the government lapse in the cooperation. Hence the firms that pocket the carry forwards ultimately face heavy losses. The probability of costly bankruptcy is lowered and a progress in corporate tax rates induces the firms to smooth their profits. There also is an input of the asymmetric Information for the multinational firms to hedge. Two types of asymmetric information are sought. One is the discerning managerial ability through hedging shareholders who can better discern the managerial ability and fire incompetent managers, and the other is the costly external financing which reduces the probability of insufficient funds to finance positive NPV projects. What we understand by the term managerial Risk Aversion is that the managers are usually less diversified than the regular shareholders as they have human capital and future compensations tied to the firm. Hence it ideally provides an incentive for corporate hedging as the risk management can lower equilibrium managerial compensation. The managers will hedge less as long as the expected utility is a convex function of the firm’s value4. Their utility acts as the concave function of their personal wealth. Hence managers with more important option holdings tend to hedge less because the resultant options create a convex relation between managers utility and firms value. The managers who are paid with stock options tend to hedge more. The compensation packages lead to a concave function between the managers expected utility and the firms’ value to encourage managers to hedge more.5 Corporate hedging is also based on the explanation of agency conflicts between managers, shareholders and debt holders. Corporate hedging reduces either the overinvestment or underinvestment costs due to unexamined managerial actions6. Corporate hedging is however the game of highly qualified managers to voice their superior abilities. A company enters a sensitive transaction of financial prices offsetting business changes, and this is the byproduct of hedging. The Hedging objectives are different for every firm. Costly external capital is also a motivating factor behind corporate hedging.7Due to informational asymmetries the cost of external capital may exceed as compare to the internal costs. In this case hedging ensures that the firm has enough internal revenue to take part in any investment opportunities. The firm on the other hand may under invest when the internal funds fall short to invest in opportunities. Here the financial derivatives can be used to shift the internal generated funds. There are few steps that have to be taken for the process of hedging to be effective by the corporate manager. First and foremost is the identification of all the risk elements involved for the company. This again falls into two categories. One is the operational risk and the other is the financial risk. Operating risks are the manufacturing and the marketing activities. The operating risks cannot be hedged as they are not traded. For example a mobile manufacturer will face operating risk as the competitor will produce a superior model and sidetrack him. Financial risks on the other hand are the risks that the companies face due to the exposure to market factors like foreign exchange rates, commodity, interest rates, and stock prices etc. These are the risks that can be hedged because of the presence of efficient markets. In Hedging it is corporate risk manager who decides which risk to take as some companies are rewarded for taking risks .like for example the mobile company would be rewarded for launching a superior model or taking up a successful marketing strategy. If however such a company makes a bet on the exchange rate, it will have little effect on the stock appreciating it. Also unless a company’s potential loss is not large enough the benefits of hedge may not outweigh the costs and in such a case there will be no use of hedging. The corporate risk managers tend to construct hedges based on interest rates, and other market factors but the best outcomes have been when the risk managers have taken the markets as unpredictable. The establishment of appropriate goals in hedging is also very important and it minimizes the fear of loss on derivative transaction. Further to evaluate the cost of hedging the risk manager must weigh it with the cost of non- hedging. For company’s managers to be thinking of the hedging program they must have an understanding of the derivative tools. The derivative options consist of forwards and options. These further comprise some basic building blocks which are as follows Forwards       Options Swaps         Caps Futures       Floors FRAs          Puts Locks         Calls          Swaptions Hedging requires for the systems internal policies controls and procedure to be properly made use of .A companies hedging policy curtails what it can hedge and what cannot be hedged also it identifies the mangers that will be responsible to hedge. The company can set limits as to the national value of the hedges. It further ensures that the top management and the company’s board of directors are at all times aware of the hedging taking place. A firm’s exposure to financial price risk is another reason for hedging as this markedly improves or maintains the efficiency of the firm. Companies cannot exist alone. They have to be in constant competition with other domestic companies in their vicinity and with companies located in other countries producing similar goods to be placed in the global marketplace for sale. Most importantly, hedging is dependent on the firms shareholders preferences. Many shareholders are of the nature that they do not partake in any risk regarding their company. while there are other companies whose shareholders see more practically towards risk taking Basically it is the opinions of the shareholders and their views regarding price risk that effect the companies policies , so we can say that two similar companies being in the same vicinity may have different policies just because their shareholders share different views on price fluctuations. Lower volatility of cash flows incurs lower bankruptcy costs. Moreover, corporate hedging can also align the availability of internal resources with the need for investment funds, helping firms to avoid costly external financing. Resultant decreased volatility of cash flows, cushions the risk aversion of managers that lapse change thereby increasing the effectiveness of managerial incentive structures by eliminating risk in the presence of convex tax schedules, corporate risk management reduces the corporate tax burden. There are many problems that have to be dealt while a company hedges. The hedging problem which is basically incurred is the Balancing of uncertainty and opportunity loss .There is also Risk aversion that has to be dealt and finally the preferences, of the shareholders. Undoubtedly forming hedging policy is a strategic decision. Importance of Hedging is such that its success or failure make or break a firm. To elaborate it further we consider a Canadian beverage company, 70% of whose product is sold in to customers located all over the world in US dollars. The determinant being the US dollar, hence all sales occurring in US dollar. Deal is made between the companies for say US $ 15 million worth of the said product. Also that in one months time they will receive payment into their US dollar accounts. Now they do have in mind that the foreign rates can fluctuate and that they are bound to the contract to be paid in one months’ time in US dollars and so there is the risk that there could be changes in the rate of exchange for the Canadian dollar against the US dollar. The problem arises here. 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. Here the problem has two dimensions that is Uncertainty and opportunity. Now to say if company does not hedge the transaction so they do not know with any assurance the rate of exchange at which they can exchange the US$15 million when it is received. So it could be profitable if the rate is increased or they might be at a loss if the rate falls. Let’s put the rate at 2.1100 and the prevailing one month forward outright rate at which they could hedge themselves 2.1100. To remove the uncertainty of the situation but with the opportunity loss we mean if they go ahead with the contract thereby getting legally bound to buy Canadian dollars and sell US dollars for delivery on the same date as the delivery date on their beverage contract, they have fixed the rate at 2.1100. If the Canadian dollar falls because of some unforeseen reason and in one months time and the rate turns out to be 2.1400, then they would have been facing loss of Canadian dollars. Hence the infinite risk of opportunity loss. To address both opportunity and certainty Instruments called derivatives or derivative products are used. Most financial institutions make markets in panoply of risk management solutions involving derivative products. These could be stand-alone solutions or packages or combinations. Derivative products are financial instrument of whose price is dependent indirectly on the behavior of a financial price. Lets take the example say the exchange rate of Canadian dollar/US dollar varies from day to day. When the Canadian dollar becomes stronger Canadian dollar call becomes more valuable. If the Canadian dollar gets weaker, the Canadian dollar becomes less valuable. So say one does not enter into a forward contract instead the company purchases a Canadian dollar call struck at 2.1100 for a premium from one of its financial institution counterparties. This 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 are best described as tradeoffs. Here the tradeoff is between uncertainty and opportunity loss. It must be noted that this was one of the possible risk management solutions to the problem. Multitude of other possibilities with different tradeoffs could be used to manage exposures. The highlighting factor in hedging is to choose amongst the solutions wisely. It is not about a forward contract but it is about choosing the best possible option Hedging objectives are also the reasons behind the hedging of multinational firms. A hedge is a financial instrument whose sensitivity to a particular financial price offsets the sensitivity of the firms core business to that price. In hedging, there are a number of issues that present themselves. One objective is the Reduction in variability of corporate income this means in the corporate world some of the best-articulated hedging programs will choose the reduction in the variability of corporate income as an appropriate target. This often happens side by side with the notion that an investor purchases the stock of the company in order to take advantage of their core business expertise. Another is Hedging cross border cash flows. While there are other companies that just believe that engaging in an outright transaction to hedge each of their cross-border cash flows in foreign exchange would be sufficient to deem themselves hedged. But by this they are exposing their companies to unforeseen potential opportunity losses. And thereby it could easily impact their relative performance. There is also the Firms exposure to financial price risk which includes Independent measures and quantifications of exposures. It is crucial and mandatory to have a check and a measure on a daily basis some notion of the firms 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. This holds true for companies with foreign exchange revenue in billions and must take measures for financial price risk. Of the many risks the company is exposed to one is that of Transactional risk which reflects the pejorative impact of fluctuations in financial prices and 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$15 million contract. Or, the funding problem of the company could be described as transactional risk. Translation risks are those risks that describe the changes in the value of a foreign asset because of changes in financial prices, such as the foreign exchange rate. Another risk factor is responsible for hedging and that is Economic exposure. This means the impact of fluctuations in financial prices on the business of the firm. In developing markets economies fluctuate sharply that is to say that they could devalue at any given time. Let’s say markets retain their high technology manufacturing infrastructure, what resulting effect will this have on accompany in Switzerland have that has sales only in Switzerland? If this country floods the market with cheap chips in a desperate effort to obtain hard currency, it could mean that the domestic manufacturer would end in serious trouble. Hedging designs available to the corporate Treasurer and their working in different pricing environments is also a risk element. A corporate treasurer must know the best time to use which instrument. The ability to function within the shareholder delineated limits while choosing optimal hedging structure in regards to a definite exposure and economic environment marks the difference between mediocre corporate treasurers from that of an excellent one. It is not a written rule that for every environment every structure will work as well. Hence it is the task of corporate treasury to cater for the exposure with derivatives fitting the preferences and views of the board of directors. Companies take into consideration what to hedge in which they Define and measuring companies risk profile, Risks the firm is facing, Understanding risk characteristics. Defining some of the hedging strategies means how much to hedge. Clearly defining risk taking and balancing costs of hedging and hedging benefits. The companies hedge by establishing rigorous risk control projects, risk control. Conclusion Imperfections in capital markets causes corporate hedging to elevate, Shareholder value with a direct effect on agency costs, Costly external financing, Direct and indirect costs of bankruptcy, Taxes. Corporate hedging further alleviates Underinvestment, asset substitution problems. Importance of Hedging is such that it can either elevate a company status or very easily be its downfall. If the process of Hedging is carried out well then it allows the management to become more focus orientated towards the betterment of the business by cutting on to the resources and minimizing risks that are not central. As hedging involves the reduction in cost of stabilized Earnings and capital it automatically increases shareholder value. REFERENCES: 1. Adam, T., S., Dasgupta and S., Titman, 2007, Financial Constraints Competition and Hedging in Industry equilibrium, forthcoming, Journal of finance. 2. Eiteman, Stonehill, Moffett, 2001. 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