Fundamentals of Corporate Finance - Assignment Example

I. Introduction This paper aims to explain the purpose of corporate hedging as well as critically evaluate the arguments against and for corporate hedging. On one hand, there are some who proposes against hedging using derivatives. According to them, a company may not hedge, as shareholders are well-diversified and they can incorporate hedging in their investment decisions. According to the argument, risks such as interest rate risks and foreign currency risks are unsystematic, therefore they can easily be diversified by investors. On the other hand, proponents of corporate hedging say that hedging is indeed important. In this age of globalisation, many companies conduct businesses in countries other than their own. With opportunities in new markets come various types of risks—business risks, macro environmental risks, as well as foreign exchange risks (Pattichis et al. 2004). When a company conducts a business outside the country where it is based, the company is said to be exposed to some foreign exchange risks, where the fluctuations in the differences between the home countrys currency and the host countrys currency may result in adverse impacts in the companys income from international operations, as well as its balance sheet. II. Body A. Explain the purpose of corporate hedging i. Accurate evaluation of performance of international subsidiaries In this age of globalisation, many companies conduct businesses in countries other than their own. With opportunities in new markets come various types of risks—business risks, macro environmental risks, as well as foreign exchange risks (Pattichis et al. 2004). When a company conducts a business outside the country where it is based, the company is said to be exposed to some foreign exchange risks, where the fluctuations in the differences between the home countrys currency and the host countrys currency may result in adverse impacts in the companys income from international operations, as well as its balance sheet. Companies need to protect themselves from these risks; a drastic change in the exchange rate between the home countrys currency and that of the host country can result in significant gains or losses (Nazarboland 2003). Aside from this, those which are otherwise very profitable international ventures of the company, due to fluctuations in the foreign exchange rate, may seem to be a losing business. For companies that have significant foreign direct investments across the globe, in order to assess more accurately the performance of their international subsidiaries, managing the foreign exchange risk is very important (Collier et al. 1990). Also, these differences will have a significant effect on the parent companys reported earnings as well. ii. Translation exposure When companies have investments outside their home countries, these investments are usually exposed to foreign exchange risk. There are three types of exposure to foreign exchange risk—translation exposure, transaction exposure and economic exposure. Translation exposure occurs because of the differences in the currency that the parent company uses, and the currency that the subsidiary in the other country uses (Nazarboland 2003). When reporting the earnings of subsidiaries, these figures have to be translated to the parent companys currency. Translation exposure occurs because of this. When drastic fluctuations in the foreign exchange rates occur, it can result in huge losses or gains (Nazarboland 2003). In order to avoid these extreme scenarios, it is therefore important to manage foreign exchange risk. iii. Economic exposure Economic exposure is a firms overall exposure to foreign exchange risk (Collier et al. 1990). Because the fluctuation in foreign exchange can impact the companys future cash flows, the companys economic value is affected. This type of exposure tends to reflect the economic effect of both transaction and translation exposures. Although economic exposure is hard to describe on operating terms, managing it is important because of its direct effect on the companys economic value (Collier et al. 1990). B. Critically evaluate the arguments against corporate hedging Financial risks are comprised of two components—systematic and unsystematic or unique (Brealey, Myers & Marcus 2004). A company can eliminate its unsystematic risk by means of diversification. The risk after the company minimises the unsystematic risk, is the systematic risk, or risk that cannot be eliminated as all businesses within an economy are exposed to it (Brealey, Myers & Marcus 2004). If a companys stock is too volatile, an investor can offset this risk by including other less volatile stocks in its portfolio (Beja 1972). This is called diversification; by diversifying the company minimises the risk inherent to the company. This volatility is a function of the investors perception of risk. When a business operates, its operations are subject not only to its ability to manufacture and sell its products and services, but are also subject to macro environmental forces, or external forces to the firm that can impact the industry it operates in (Gwangheon & Sarkar 2007). Academicians over the years have come up with the idea that risks are usually not only inherent to a firms operations, but a part of it is a factor of the risks in relation to the system an economy-wide peril that threatens all businesses (Brealey, Myers, Marcus 2004). Therefore after the unsystematic risk is minimised by diversifying an investors portfolio, what remains is the systematic risk, which all businesses are exposed to when the macro environment factors go against the market (Eddy 1978). The major argument against hedging is that risks such as interest rate risks and foreign exchange risks are unsystematic risks, therefore they can easily be diversified away by investors (Teck 1974). This can come in the form of adjusted correlation of a companys stock to the market movement. That is why, according to McNulty et al., for diversifying investors, the correlation will serve as some hedge in terms of the stock value when a stock is being incorporated in the investors portfolio of investments (2002). Since shareholders are well-diversified, and they can include these analysis in their investment decisions, there is no point for a company to hedge. C. Critically evaluate the arguments for corporate hedging i. Managing transaction exposure: foreign currency derivatives Firms manage transaction exposure by using foreign currency derivatives (Williams 2004). In the United Kingdom, there are five types of derivative instruments that are used—the over the counter forwards, futures, over the counter options, exchange options, and swaps (Mallin et al. 2001). In a study by Mallin et al., OTC forwards is the most commonly used for hedging currency risks, followed by OTC options, and then swaps (2001). Various reasons have been gathered from UK companies with their use of derivatives (Demirag & De Fuentes 1999). These include “to hedge contractual commitments; to hedge expected transactions which are less than 12 months; to hedge expected transactions which are more than 12 months; to hedge foreign dividends; to hedge balance sheet; to hedge economic/competitive exposure; to reduce funding costs by arbitraging the markets; [and] to reduce funding costs by taking a view (Mallin et al. 2001, 71).” Transaction exposure is more commonly managed than translation exposure because of its more direct effect on profitability. Transactions such as receivables, payables, and fixed-price sales and purchase contracts, because of the time lag before these transactions are completed are exposed to the volatility of foreign exchange rates (Makar & Huffman 2008). When translation exposure to foreign exchange risk occurs because of the differences in the currency used in accounting for the operations, transaction exposure occurs when the firm engages in different transactions that require the use of another currency, and where the time frame before the transaction is completed may result in drastic changes in foreign exchange rates which could affect the respective budgets of the company (Collier & Davis 1985). Some of these transactions include receivables, payables, and fixed-prices sales and purchase contracts. When firms engage in these transactions, such as a purchase of material from another country with a different currency, these transactions normally complete after a certain period. By the time the period completes, the fluctuation in foreign exchange rates can have an impact on the contract price of the transaction (Collier & Davis 1985). If a firm budgets for a certain purchase order from another country under a certain currency, if the foreign exchange rates become unfavourable to its currency, it will pay more than it has budgeted for that certain transaction. These fluctuations can have huge effects on the firms profitability (Collier & Davis 1985). In order to avoid these instances, managing foreign exchange risk is crucial. In using derivatives, certain objectives are kept in mind by these companies. The highest of these include hedging for account earnings, being followed by hedging for cash flows, then hedging for the market value of the firm, with hedging for balance sheet ratios as the objective given the least importance (Mallin et al. 2001, 72). Hedging is most important when companies consider capital budgeting decisions overseas. Because the capital budgeting decision already poses some risk to the company, these risks can be aggravated because of fluctuations in foreign currency risks (Brealey, Myers, & Marcus 2004). A company maybe reluctant to invest although a project has free cash flows that result in a positive net present value because its managers worry about the effect of the fluctuations in currencies that could affect the companys prospect in another country or geographical area with a different currency. With hedging, the company may focus solely on the project and the net benefits to it in terms of the incremental value that the project may provide (Brealey, Myers, & Marcus 2004). Mitigating foreign currency risks forces managers to look at the prospects of approving a project based on its profitability and ability to generate value as the basis, and not the risks that are associated with the fluctuations between the foreign exchange rates of the currencies (Brealey, Myers, & Marcus 2004). III. Conclusion When companies have investments outside their home countries, these investments are usually exposed to foreign exchange risk. Transactional risks, or foreign exchange risk arising from transaction exposure have more direct effect on the profitability of the company. Hedging serves to minimise these risks. There are both proponents and opponents when it comes to hedging. The opponents of hedging suggest that the major argument why foreign currency risks may not be hedged is because investors can easily incorporate hedging theses risks in their investment decisions because they are well-diversified. Because foreign currency risks are unsystematic risks, they can easily be diversified by investors through their choice of portfolios. This has been a valid argument. On the other hand, there are the proponents of hedging. When it comes to transactions that a company undertakes, hedging serves an important role. Because of the lag before transactions are completed, the fluctuation in the foreign exchange rate can have a significant effect on the contract price of the transaction. In order to minimise these risks, they have to be managed. Some of the arguments of proponents of hedging say that hedging helps in smoothing out a companys income and expense figures, as well as its balance sheet figures which are exposed to foreign currency risks, because the figures will be no longer be subject to fluctuation when the foreign currency risk is already hedged. Another strong argument of proponents of hedging – hedging is most important when companies consider capital budgeting decisions overseas. Because the capital budgeting decision already poses some risk to the company, these risks can be aggravated because of fluctuations in foreign currency risks. With hedging, the company may focus solely on the project and the net benefits to it in terms of the incremental value that the project may provide. Mitigating foreign currency risks forces managers to look at the prospects of approving a project based on its profitability and ability to generate value as the basis, and not the risks that are associated with the fluctuations between the foreign exchange rates of the currencies. A conclusion is made after considering the two sides when it comes to hedging. Although investors can hedge their positions by means of diversification, because of a companys fiduciary relationship to them in terms of creating value, the argument about capital budgeting decisions overseas, where hedging is important in order for companies to analyse the true ability of an investment decision to create value, without regard to the fluctuations in the currencies exchange rates, which are not inherent to the project. Hedging should definitely be used by companies. References BEJA, AVRAHAM. 1972. "ON SYSTEMATIC AND UNSYSTEMATIC COMPONENTS OF FINANCIAL RISK." Journal of Finance 27, no. 1: 37-45. 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