What is hedging?

Why do companies
hedge?
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 euity prices. !he effect of
changes in these prices on reported earnings can be overwhelming. "ften,
you will hear companies say in their financial statements that their income
was reduced by falling commodity prices or that they en#oyed a windfall
gain in profit attributable to the decline of the Canadian dollar.
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. While
there has been a great deal of negative attention paid to derivatives in the mainstream
press, the opportunities they provide make derivatives a necessary part of the future of
any corporation. Future articles in this series will identify the benefits and drawbacks of
individual derivatives structures and explain some of the breakdowns in the application of
derivatives by corporate end-users.
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. he does not buy the stock in order to take advantage of a
falling !anadian dollar, knowing that the company exports over "#$ of its product to
overseas markets. This is the insurance argument in favour of hedging. imilarly,
companies are expected to take out insurance against their exposure to the effects of theft
or fire.
%y hedging, in the general sense, we can imagine the company entering into a transaction
whose sensitivity to movements in financial prices offsets the sensitivity of their core
business to such changes. &s we shall see in this article and the ones that follow, hedging
is not a simple exercise nor is it a concept that is easy to pin down. 'edging ob(ectives
vary widely from firm to firm, even though it appears to be a fairly standard problem, on
the face of it. &nd the spectrum of hedging instruments available to the corporate
Treasurer is becoming more complex every day.
&nother reason for hedging the exposure of the firm to its financial price risk is to
improve or maintain the competitiveness of the firm. !ompanies 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. &gain, a
pulp-and-paper company based in !anada has competitors located across the country and
in any other country with significant pulp-and-paper industries, such as the candinavian
countries.
!ompanies that are the most sophisticated in this field recogni)e 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 it is not pe(oratively affected by
movements in these prices. This level of sophistication depends on the firm*s experience,
personnel and management approach. +t will also depend on their competitors. +f 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.
,ost 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. +t 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.
!he hedging problem
The core problem when deciding upon a hedging policy is to strike a balance between
uncertainty and the risk of opportunity loss. +t is in the establishment of balance that we
must consider the risk aversion, the preferences, of the shareholders. ,ake no mistake
about it. etting hedging policy is a strategic decision, the success or failure of which can
make or break a firm.
!onsider the example of the !anadian pulp-and-paper company from before, "#$ of
whose product is sold in - dollars to customers located all over the world. The -
dollar here is called the price of determination because all sales of pulp-and-paper are
denominated in - dollars.
They close a deal for -./0 million worth of product and they know that in one month*s
time they will receive payment into their - dollar accounts. 'owever, they understand
that from the inception of the contract which binds them to have receivables in - dollars
in one month*s time they are exposed to changes in the rate of exchange for the !anadian
dollar against the - dollar.
+mmediately, they are faced with a problem. &s a !anadian company, they will have to
repatriate those - 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 dimensions1 uncertainty and opportunity.
+f 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 -./0 million when it is delivered. +t 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.
2et*s call the prevailing spot rate, for argument*s sake, /.#300 and the prevailing one
month forward outright rate at which they could hedge themselves /.#3/0.
+f they do enter into a forward contract in which they obligate themselves to buy
!anadian dollars and sell - 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 4uestion at what rate this exchange will be. +t will be /.#3/0.
%ut, they have now taken on infinite risk of opportunity loss. +f the !anadian dollar
weakens because of some unforeseen event and in one month*s time the prevailing spot
rate turns out to be /.#500, then they have foregone 670,000 !anadian dollars. This is
their opportunity loss.
&re there instruments that address both certainty and opportunity loss8 Fortunately, there
are. They are called derivatives or derivative products. ,ost financial institutions make
markets in a panoply of risk management solutions involving derivative products. ome
of them come as stand-alone solutions and others are presented as packages or
combinations.
& derivative product is a financial instrument whose price depends indirectly on the
behaviour of a financial price.
For example, the price of a foreign exchange option on the !anadian dollar in which our
company had the right but not the obligation to buy !anadian dollars and sell - dollars
at a pre-set strike price will vary on a day-to-day basis with the movement in the
!anadian dollar9- dollar exchange rate. +f the !anadian dollar gets stronger, the
!anadian dollar call becomes more valuable. +f the !anadian dollar gets weaker, the
!anadian dollar becomes less valuable.
+nstead of entering into a forward contract to buy !anadian dollars, the pulp-and-paper
company could purchase a !anadian dollar call struck at /.#3/0 for a premium from one
of its financial institution counterparties. :oing so reduces their certainty about the rate at
which they will repatriate the - dollars but it limits their worst case in exchange for
allowing them to en(oy potential opportunity gains, again conditioned by the premium
they have paid.
:erivatives (ust like any other economic mechanism are best thought of in terms of
tradeoffs. The tradeoffs here are between uncertainty and opportunity loss.
'owever, a !anadian dollar call is only one of the possible risk management solutions to
this problem. There are do)ens of possible instruments, each of which has a differing
tradeoff between uncertainty and opportunity loss, that the pulp-and-paper 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. 'edging is not (ust
about putting on a forward contract. 'edging is about making the best possible decision,
integrating the firm*s level of sophistication, systems and the preferences of their
shareholders.
Future articles will discuss in depth the nature of some of these alternative solutions and
the ways in which firms approach these other instruments.
$edging ob#ectives
The final part of this article will introduce briefly the notion of hedging ob(ectives. ;ach
of these will be discussed in articles to follow.
;arlier, 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.
traightaway, we can see that there are a number of issues that present themselves.
First, what is the hedging objective of the firm?
ome 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 (ust 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. <et, they are exposing their companies to untold potential opportunity losses.
&nd this could impact their relative performance pe(oratively.
Second, what is the firm's exposure to financial price risk?
+t 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 4uantification of their exposures. +t 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 pe(orative 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 -./0 million contract.
Or, we could describe the funding problem of the company as a transactional risk. 'ow
do they borrow money8 'ow do they hedge the value of a loan they have taken once it is
on the books8
Translation risks describe the changes in the value of a foreign asset due to changes in
financial prices, such as the foreign exchange rate.
;conomic exposure refers to the impact of fluctuations in financial prices on the core
business of the firm. +f 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 !anada8 +f 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 (eopardy.
Third, what are the various hedging instruments available to the corporate Treasurer and
how do they behave in different pricing environments?
When is it best to use which instrument is the 4uestion 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. =ot 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.
%mportance
+t may appear that companies in which individual investors place money do not have
exposures to financial prices. &fter reading this article, the reader should have some
notion of how dangerous a misconception that can be.
!he 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.
%nvestors 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.