RISK MANAGEMENT: PROFILING AND HEDGING
KEYWORDS: Risk Management-Types Of Risk- Risk Management Process- Hedging-Financial Risk Assassination Tools - Risk assessment - Risk management – Uncertainty and Hedging
Introduction
Risk may be defined more broadly as the probability of occurrence of an adverse outcome and the severity of the consequences if the outcome does occur. MacDiarmid notes that risk analysis must begin with risk identification. The potential adverse outcomes must be listed at the outset of the risk analysis process, and it is a
good idea to include the marginal entries on the list. If adverse outcomes (e.g. diseases
caused by specific pathogens) do not appear on the list, then the risk analysis could omit
aspects of great importance for regulatory decision-making. If some adverse outcomes have such low probabilities or mild consequences that they are clearly not important, then they can be dropped from the analysis. But initially it is better to be inclusive, to err on the side of caution, and to try to anticipate unpleasant surprises. Not all the possible surprises can be anticipated; some adverse outcomes (e.g. disease outbreaks) may be essentially impossible to foresee. But in an uncertain world the best way to avoid adverse outcomes is to make good decisions, i.e. decisions based on what is known – including judgments about uncertainties - and careful consideration of what can be done, what is desirable, and what it is desirable to avoid.
Risk analysis should therefore be comprehensive, but it must remain feasible given the available time and resources. It must be directed towards assisting those responsible for making decisions to do so in a way which is consistent with scientific principles, legal requirements and public values. Clearly, these criteria are not satisfied if potentially significant diseases are omitted from the analysis. But how far does one go in carrying out a risk analysis? The answer is to go far enough to provide the decision-maker with as much assistance as possible, in the time and with the resources available. To accomplish this goal, risk analysis requires skillful judgment as well as scientific rigor’s MacDiarmid states, it is important to distinguish between risk assessment, risk management and risk communication. Risk analysis comprises all three of these elements:
`Risk assessment is the process of estimating, as objectively as possible, the
Probability that an importation would result in the entry of an exotic disease agent and that
Local livestock would be exposed to the agent. Risk assessment ought to examine the effect
Of the introduction of an exotic disease. However, very few studies of this nature have been
performed anywhere.
Risk management is the process of identifying and implementing measures which can be
Applied to reduce risk to an acceptable level and documenting the final import decision.
Risk communication is the process by which the results of risk assessment and risk
Management is communicated to decision-makers and the public. Adequate risk
Communication is essential in explaining official policies to stakeholders (such as
Established livestock industry groups), who are often aware of the risks but not the
Benefits of importations. Risk communication must also be a two-way process, with the
concerns of stakeholders being heard by officials and addressed adequately.'
3
Risk assessment and risk management are discussed in greater detail below.
Risk assessment is the process of summarizing a scientific analysis of a particular risk: What are
the probability and the severity of the adverse outcome? Full use should be made of the
objective data available, in estimating the probability of a disease outbreak. In many situations,
however, such data do not exist - usually due to a lack of experience or knowledge (e.g. about key
steps in the process by which a pathogen might be released from a host or carrier and transferred
to a local livestock population). In such situations, decision-makers must rely on judgment
in the absence of data. The most knowledgeable scientific experts should then be called
upon to make assessments of the probability of a disease outbreak, as the best basis for a
decision.
When faced with complex uncertainties, scientists may be reluctant to express a
judgment which may be used as input to a potentially controversial decision. Scientists are
often taught that probabilities should reflect frequencies in observed data, and they may be
reluctant to give their judgment in the form of a probability. Assessment of judgmental
probabilities is often best accomplished by conducting the probability assessment
through a series of steps, as illustrated in the example presented below (see `Example of Risk
Analysis').
It is also often useful to distinguish degrees of severity in the consequences of an adverse
event. In the case of an exotic animal disease outbreak, it may be very difficult to predict how
far an epidemic may spread once the disease is introduced. In the example below, the
adverse outcome is considered to be one replication of the life cycle of the pathogen in its new
home. If the pathogen can replicate once, its progeny are likely to repeat the cycle many
more times.
Risk management is usually the responsibility of administrators, often in government but
sometimes in the private sector, in response to regulations established by national or
international authorities. Risk managers must consider not only scientific factors, but also
the legal requirements that define admissible alternatives, and they must examine not only
the potential consequences of their decisions for animal health, but also the economic,
political and social consequences of their decisions. In many ways, therefore, risk management is
also an art based on judgment, rather than a formula to be applied (as might be the case in
engineering situations, for example, where the scientific basis of the risks involved is well
understood in quantitative terms).
Decisions are usually delegated from a higher authority and, at least for most of the nations
represented at this Symposium, the highest authority is ultimately the electorate, i.e.
the general public. Public understanding of and support for the decision-making process are
critical, especially in situations where the potential adverse outcome has serious health or
economic consequences on a regional or national scale. In the face of conflict and controversy,
decision-makers must be able to demonstrate that they are making good decisions. In most
situations, such a demonstration requires in-depth, two-way risk communication about the
assumptions and findings of the risk assessment and the choice of risk management strategy.
Stakeholders may be interested in the details of the risk analysis, as well as the overall
results. Often the analysis process leads to important insights motivating the choice of a
risk management alternative. When stakeholders understand these insights, they are
better able to understand why the decision taken was a good one - even if it may involve
some additional cost or risk to their interests
To manage risk, you first have to understand the risks that you are exposed to. This process of developing a risk profile thus requires an examination of both the immediate risks from competition and product market changes as well as the more indirect effects of macroeconomic forces. We will begin this paper by looking at ways in which we can develop a complete risk profile for a firm, where we outline all of the risks that a firm is exposed to an estimate the magnitude of the exposure. In the second part of the chapter, we turn to a key question of what we should do about these risks. In general, we have three choices. We can do nothing and let the risk pass through to investors in the business – stockholders in a publicly traded firm and the owners of private businesses. We can try to protect ourselves against the risk using a variety of approaches – using options and futures to hedge against specific risks, modifying the way we fund assets to reduce risk exposure or buying insurance. Finally, we can intentionally increase our exposure to some of the risks because we feel that we have significant advantages over the competition. In this chapter, we will consider the first two choices and hold off on the third choice until the next chapter.
Risk Profile
Every business faces risks and the first step in managing risk is making an inventory of the risks that you face and getting a measure of the exposure to each risk. In this section, we examine the process of developing a risk profile for a business and consider some of the potential pitfalls. There are four steps involved in this process. In the first step, we list all risks that a firm is exposed to, from all sources and without consideration to the type of risk. We categorize these risks into broad groups in the second step and analyze the exposure to each risk in the third step. In the fourth step, we examine the alternatives available to manage each type of risk and the expertise that the firm brings to dealing with the risk.
Step 1: A listing of risks
Assume that you run a small company in the United States, packaging and selling premium coffee beans for sale to customers. You may buy your coffee beans in Columbia, sort and package them in the California and ship them to your customers all over the world. In the process, you are approached to a multitude of risks. There is the risk of political turmoil in Columbia, compounded by the volatility in the dollar-peso exchange rate. Your packaging plant in California may sit on top of an earthquake fault line and be staffed with unionized employees, exposing you to the potential for both natural disasters and labor troubles. Your competition comes from other small businesses offering their own gourmet coffee beans and from larger companies like Starbucks that may be able to get better deals because of higher volume. On top of all of this, you have to worry about the overall demand for coffee ebbing and flowing, as customers choose between a wider array of drinks and worry about the health concerns of too much caffeine consumption.
Not surprisingly, the risks you face become more numerous and complicated as you expand your business to include new products and markets, and listing them all can be exhausting. At the same time, though, you have to be aware of the risks you face before you can begin analyzing them and deciding what to do about them.
Step 2: Categorize the risks
A listing of all risks that a firm faces can be overwhelming. One step towards making them manageable is to sort risk into broad categories. In addition to organizing risks into groups, it is a key step towards determining what to do about these risks. In general, risk can be categorized based on the following criteria:
a. Market versus Firm-specific risk: In keeping with our earlier characterization of risk in risk and return models, we can categorize risk into risk that affects one or a few companies (firm-specific risk) and risk that affects many or all companies (market risk). The former can be diversified away in a portfolio but the latter will persist even in diversified portfolios; in conventional risk and return models, the former have no effect on expected returns (and discount rates) whereas the latter do.
b. Operating versus Financial Risk: Risk can also be categorized as coming from a firm’s financial choices (its mix of debt and equity and the types of financing that it uses) or from its operations. An increase in interest rates or risk premiums would be an example of the former whereas an increase in the price of raw materials used in production would be an example of the latter.
c. Continuous Risks versus Event Risk: Some risks are dormant for long periods and manifest themselves as unpleasant events that have economic consequences whereas other risks create continuous exposure. Consider again the coffee bean company’s risk exposure in Columbia. A political revolution or nationalization of coffee estates in Columbia would be an example of event risk whereas the changes in exchange rates would be an illustration of continuous risk.
d. Catastrophic risk versus Smaller risks: Some risks are small and have a relatively small effect on a firm’s earnings and value, whereas others have a much larger impact, with the definition of small and large varying from firm to firm. Political turmoil in its Indian software operations will have a small impact on Microsoft, with is large market cap and cash reserves allowing it to find alternative sites, but will have a large impact on a small software company with the same exposure. Some risks may not be easily categorized and the same risk can switch categories over time, but it still pays to do the categorization.
Step 3: Measure exposure to each risk
A logical follow up to categorizing risk is to measure exposure to risk. To make this measurement, though, we have to first decide what it is that risk affects. At its simplest level, we could measure the effect of risk on the earnings of a company. At its broadest level, we can capture the risk exposure by examining how the value of a firm changes as a consequence.
Earnings versus Value Risk Exposure
It is easier to measure earnings risk exposure than value risk exposure. There are numerous accounting rules governing how companies should record and report exchange rate and interest rate movements. Consider, for instance, how we deal with exchange rate movements. From an accounting standpoint, the risk of changing exchange rates is captured in what is called translation exposure, which is the effect of these changes on the current income statement and the balance sheet. In making translations of foreign operations from the foreign to the domestic currency, there are two issues we need to address. The first is whether financial statement items in a foreign currency should be translated at the current exchange rate or at the rate that prevailed at the time of the transaction. The second is whether the profit or loss created when the exchange rate adjustment is made should be treated as a profit or loss in the current period or deferred
Translation exposure matters from the narrow standpoint of reported earnings and balance sheet values. The more important question, however, is whether investors view these translation changes as important in determining firm value, or whether they view them as risk that will average out across companies and across time, and the answers to this question are mixed. In fact, several studies suggest that earnings changes caused by exchange rate changes do not affect the stock prices of firms. While translation exposure is focused on the effects of exchange rate changes on financial statements, economic exposure attempts to look more deeply at the effects of such changes on firm value. These changes, in turn, can be broken down into two types. Transactions exposure looks at the effects of exchange rate changes on transactions and projects that have already been entered into and denominated in a foreign currency.
Operating exposure measures the effects of exchange rate changes on expected future cash flows and discount rates, and, thus, on total value.
1 Monetary asset includes cash, marketable securities and some short terms assets such as inventory. They do not include real assets.
Measuring Risk Exposure
We can measure risk exposure in subjective terms by assessing whether the impact of a given risk will be large or small (but not specifying how large or small) or in quantitative terms where we attempt to provide a numerical measure of the possible effect. In this section, we will consider both approaches.
Qualitative approaches
When risk assessment is done for strategic analysis, the impact is usually measured in qualitative terms. Thus, a firm will be found to be vulnerable to country risk or exchange rate movements, but the potential impact will be categorized on a subjective scale. Some of these scales are simple and have only two or three levels (high, average and low impact) whereas others allow for more gradations (risk can be scaled on a 1-10scale).
No matter how these scales are structured, we will be called upon to make judgments about where individual risks fall on this scale. If the risk being assessed is one that the firm is exposed to on a regular basis, say currency movements, we can look at its impact on earnings or market value on a historical basis. If the risk being assessed is a low-probability event on which there is little history as is the case for an airline exposed to the risk of terrorism, the assessment has to be based upon the potential impact of such an incident.
While qualitative scales are useful, the subjective judgments that go into them can create problems since two analysts looking at the same risk can make very different Shapiro, A., 1996, Multinational Financial Management (Seventh Edition), John Wiley, New York. assessments of their potential impact. In addition, the fact that the risk assessment is made by individuals, based upon their judgments, exposes it to all of the quirks in risk assessment that we noted earlier in the book. For instance, individuals tend to weight recent history too much in making assessments, leading to an over estimation of exposure from recently manifested risks. Thus, companies over estimate the likelihood and impact of terrorist attacks right after well publicized attacks elsewhere.
Quantitative approaches
If risk manifests itself over time as changes in earnings and value, you can assess a firm’s exposure to risk by looking at its past history. In particular, changes in a firm’s earnings and value can be correlated with potential risk sources to see both whether they are affected by the risks and by how much. Alternatively, you can arrive at estimates of risk exposure by looking at firms in the sector in which you operate and their sensitivity to changes in risk measures.
1. Firm specific risk measures
Risk matters to firms because it affects their profitability and consequently their value. Thus, the simplest way of measuring risk exposure is to look at the past and examine how earnings and firm value have moved over time as a function of prespecified risk. If we contend, for instance, that a firm is cyclical and is exposed to the risk of economic downturns, we should be able to back this contention up with evidence that it has been adversely impacted by past recessions.
Consider a simple example where we estimate how much risk Walt Disney Inc. is exposed to format changes in a number of macro-economic variables, using two measures: Disney’s firm value (the market value of debt and equity) and its operating income. We begin by collecting past data on firm value, operating income and the macroeconomic variables against which we want to measure its sensitivity. In the case of the Disney, we look at four macro-economic variables – the level of long term rates measured by the 10 year treasury bond rate, the growth in the economy measured by changes in real GDP, the inflation rate captured by the consumer price index and the strength of the dollar against other currencies (estimated using the trade-weighted dollar value).
Step 4: Risk analysis
Once you have categorized and measured risk exposure, the last step in the process requires us to consider the choices we can make in dealing with each type of risk. While we will defer the full discussion of which risks should be hedged and which should not to the next section, we will prepare for that discussion by first outlining what our alternatives are when it comes to dealing with each type of risk and follow up be evaluating our expertise in dealing with that risk.
There are a whole range of choices when it comes to hedging risk. You can try to reduce or eliminate risk through your investment and financing choices, through insurance or by using derivatives. Not all choices are feasible or economical with all risks and it is worthwhile making an inventory of the available choices with each one. The risk associated with nationalization cannot be managed using derivatives and can be only partially insured against; the insurance may cover the cost of the fixed assets appropriated but not against the lost earnings from these assets. In contrast, exchange rate risk can be hedged in most markets with relative ease using market-traded derivatives contracts. A tougher call involves making an assessment of how well you deal with different risk exposures. A hotel company may very well decide that its expertise is not in making real estate judgments but in running hotels efficiently. Consequently, it may decide to hedge against the former while being exposed to the latter.
To Hedge or Not to Hedge?
Assume now that you have a list of all of the risks that you are exposed to, categorize these risks and measured your exposure to each one. A fundamental and key question that you have to answer is which of these risks you want to hedge against and which you want to either pass through to your investors or exploit. To make thus judgment, you have to consider the potential costs and benefits of hedging; in effect, you hedge those risks where the benefits of hedging exceed the costs.
The Costs of Hedging
Protecting yourself against risk is not costless. Sometimes, as is the case of buying insurance, the costs are explicit. At other times, as with forwards and futures contracts, the costs are implicit. In this section, we consider the magnitude of explicit and implicit costs of hedging against risk and how these costs may weigh on the final question of whether to hedge in the first place.
Explicit Costs
Most businesses insure against at least some risk and the costs of risk protection are easy to compute. They take the form of the insurance premiums that you have to pay to get the protection. In general, the trade off is simple. The more complete the protection against risk, the greater the cost of the insurance. In addition, the cost of insurance will increase with the likelihood and the expected impact of a specified risk. A business located in coastal Florida will have to pay more to insure against floods and hurricanes than one in the mid-west. Businesses that hedge against risks using options can also measure their hedging costs explicitly. A farmer who buys put options to put a lower bound on the price that he will sell his produce at has to pay for the options. Similarly, an airline that buys call options on fuel to make sure that the price paid does not exceed the strike price will know the cost of buying this protection.
Implicit Costs
The hedging costs become less explicit as we look at other ways of hedging against risk. Firms that try to hedge against risk through their financing choices – using peso debt to fund peso assets, for instance – may be able to reduce their default risk (and consequently their cost of borrowing) but the savings are implicit. Firms that use futures and forward contracts also face implicit costs. A farmer that buys futures contracts to lock in a price for his produce may face no immediate costs (in contrast with the costs of buying put options) but will have to give up potential profits if prices move upwards.
The way in which accountants deal with explicit as opposed to implicit costs can make a difference in which hedging tool get chosen. Explicit costs reduce the earnings in the period in which the protection is acquired, whereas the implicit costs manifest themselves only indirectly in future earnings. Thus, a firm that buys insurance against risk will report lower earnings in the period that the insurance is bought whereas a firm that uses futures and forward contracts to hedge will not take an earnings hit in that period. The effects of the hedging tool used will manifest itself in subsequent periods with the latter reducing profitability in the event of upside risk.
The Benefits of Hedging
There are several reasons why firms may choose to hedge risks, and they can be broadly categorized into five groups. First, as we noted in the last chapter, the tax laws may benefit those who hedge risk. Second, hedging against catastrophic or extreme risk may reduce the likelihood and the costs of distress, especially for smaller businesses. Third, hedging against risks may reduce the under investment problem prevalent in many firms as a result of risk averse managers and restricted capital markets. Fourth, minimizing the exposure to some types of risk may provide firms with more freedom to fine tune their capital structure. Finally, investors may find the financial statements of firms that do hedge against extraneous or unrelated risks to be more informative than firms that do not.
a. Tax Benefits
A firm that hedges against risk may receive tax benefits for doing so, relative to an otherwise similar firm that does not hedge against risk. There are two sources for these tax benefits. One flows from the smoothing of earnings that is a consequence of effective risk hedging; with risk hedging, earnings will be lower than they would have been without hedging, during periods here the risk does not manifest itself and higher in periods where there is risk exposure. To the extent that the income at higher levels gets taxed at higher rates, there will be tax savings over time to a firm with more level earnings. To see why, consider a tax schedule, where income beyond a particular level (say Rs. 1 billion) is taxed at a higher rate – i.e., a windfall profit tax. Since risk management can be used to smooth out income over time, it is possible for a firm with volatile income to pay less in taxes over time as a result of risk hedging.
b. Better investment decisions
In a perfect world, the managers of a firm would consider each investment opportunity based upon its expected cash flows and the risk that that investment adds to the investors in the firm. They will not be swayed by risks that can be diversified away by these investors, substantial though these risks may be, and capital markets will stand ready to supply the funds needed to make these investments.
c. Distress Costs
Every business, no matter how large and healthy, faces the possibility of distress under sufficiently adverse circumstances. While bankruptcy can be the final cost of distress, the intermediate costs of being perceived to be in trouble are substantial as well. Customers may be reluctant to buy your products, suppliers will impose stricter terms and employees are likely to look for alternative employment, creating a death spiral from which it is difficult to recover. These “indirect” costs of distress can be very large, and studies that try to measure it estimate they range from 20% to 40% of firm value.9 Given the large costs of bankruptcy; it is prudent for firms to protect themselves against risks that may cause distress by hedging against them. In general, these will be risks that are large relative to the size of the firm and its fixed commitments (such as interest expenses). As an example, while large firms with little debt like Coca Cola can easily absorb the costs of exchange rate movements, smaller firms and firms with larger debt obligations may very well be pushed to their financial limits by the same risk. Consequently, it makes sense for the latter to hedge against risk. The payoff from lower distress costs show up in value in one of two ways. In a conventional discounted cash flow valuation, the effect is likely to manifest itself as a lower cost of capital (through a lower cost of debt) and a higher value. In the adjusted present value approach, the expected bankruptcy costs will be reduced as a consequence of the hedging. To the extent that the increase in value from reducing distress costs exceeds the cost of hedging, the value of the firm will increase. Note that the savings in distress costs from hedging are likely to manifest themselves in substantial ways only when distress costs are large. Consequently, we would expect firms that have borrowed money and are exposed to significant operating risk to be better candidates for risk Shapiro,
d. Capital Structure
Closely related to the reduced distress cost benefit is the tax advantage that accrues from additional debt capacity. Firms that perceive themselves as facing less distress costs are more likely to borrow more. As long as borrowing creates a tax benefit, this implies that a firm that hedges away large risks will borrow more money and have a lower cost of capital. The payoff will be a higher value for the business. The evidence on whether hedging does increase debt capacity is mixed. In supporting evidence, One study documents a link between risk hedging and debt capacity by examining 698 publicly traded firms between 1998 and 2003. This study notes that firms that buy property insurance (and thus hedge against real estate risk) borrow more money and have lower costs of debt than firms that do not.Another study provides evidence on why firms hedge by looking at firms that use derivatives. The researchers conclude that these firms do so not in response to convex tax functions but primarily to increase debt capacity and that the these tax benefits add approximately 1.1% in value to these firms. They also find that firms with more debt are more likely to hedge and that hedging leads to higher leverage.
e. Informational Benefits
Hedging away risks that are unrelated to the core business of a firm can also make financial statements more informative and investors may reward the firm with a higher value. Thus, the changes in earnings for a multinational that hedges exchange rate risk will reflect the operating performance of the firm rather than the luck of the draw when it comes to exchange rates. Similarly, a hotel management company that has hedged away or removed its real estate risk exposure can be judged on the quality of the hotel management services that it provides and the revenues generated, rather than the profits or losses created by movements in real estate prices over time.
In a 1995 paper, DeMarzo and Duffie explore this issue in more detail by looking at both the informational advantages for investors when companies hedge risk and the effect on hedging behavior of how much the hedging behavior is disclosed to investors. They note that the benefit of hedging is that it allows investors to gauge management quality more easily by stripping extraneous noise from the process. They also note a possible cost when investors use the observed variability in earnings as a measure of management quality; in other words, investors assume that firms with more stable earnings have superior managers. If managers are not required to disclose hedging actions to investors, they may have the incentive to hedge too much risk; after all, hedging reduces earnings variability and improves managerial reputation.
The Prevalence of Hedging
A significant number of firms hedge their risk exposures, with wide variations in which risks get hedged and the tools used for hedging. In this section, we will look at some of the empirical and survey evidence of hedging among firms.
What risks are most commonly hedged?
While a significant proportion of firm’s hedge against risk, some risks seem to be hedged more often than others. In this section, we will look at the two most widely hedged risks at U.S. companies – exchange rate risk and commodity price risk – and consider how and why firms hedge these risks.
Exchange Rate Risk
Surveys consistently indicate that the most widely hedged risk at U.S. firms remains currency risk. There are three simple reasons for this phenomenon. a. It is ubiquitous: It is not just large multi-national firms that are exposed to exchange rate risk. Even small firms that derive almost all of their revenues domestically are often dependent upon inputs that come from foreign markets and are thus exposed to exchange rate risk. An entertainment software firm that gets its software written in India for sale in the United States is exposed to variations in the U.S. dollar/ Indian Rupee exchange rate.
b. It affects earnings: Accounting conventions also force firms to reflect the effects of exchange rate movements on earnings in the periods in which they occur. Thus, the earnings per share of firms that do not hedge exchange rate risk will be more volatile than firms that do. As a consequence, firms are much more aware of the effects of the exchange rate risk, which may provide a motivation for managing it.
c. It is easy to hedge: Exchange rate risk can be managed both easily and cheaply. Firms
can use an array of market-traded instruments including options and futures contracts to reduce or even eliminate the effects of exchange rate risk.
Commodity Price Risk
While more firms hedge against exchange rate risk than commodity risk, a greater percentage of firms that are exposed to commodity price risk hedge that risk. Tufano’s study of gold mining companies, cited earlier in this section, notes that most of these firms hedge against gold price risk. While gold mining and other commodity companies use hedging as a way of smoothing out the revenues that they will receive on the output, there are companies on the other side of the table that use hedging to protect themselves against commodity price risk in their inputs. For instance, Hershey’s can use futures contracts on cocoa to reduce uncertainty about its costs in the future.
Does hedging increase value?
Hedging risks has both implicit and explicit costs that can vary depending upon the risk being hedged and the hedging tool used, and the benefits include better investment decisions, lower distress costs, tax savings and more informative financial statements. The trade off seems simple; if the benefits exceed the costs, you should hedge and if the costs exceed the benefits, you should not. This simple set-up is made more complicated when we consider the investors of the firm and the costs they face in hedging the same risks. If hedging a given risk creates benefits to the firm, and the hedging can be done either by the firm or by investors in the firm, the hedging will add value only if the cost of hedging is lower to the firm than it is to investors. Thus, a firm may be able to hedge its exposure to sector risk by acquiring firms in other businesses, but investors can hedge the same risk by holding diversified portfolios. The premiums paid in acquisitions will dwarf the transactions costs faced by the latter; this is clearly a case where the risk hedging strategy will be value destroying. In contrast, consider an airline that is planning on hedging its exposure to oil price risk because it reduces distress costs. Since it is relatively inexpensive to buy oil options and futures and the firm is in a much better position to know its oil needs than its investors, this is a case where risk hedging by the firm will increase value.
Risk Management Process
Alternative techniques for hedging risk
If you decide to reduce your exposure to a risk or risks, there are several approaches that you can use. Some of these are integrated into the standard investment and financing decisions that every business has to make; your risk exposure is determined by the assets that you invest in and by the financing that you use to fund these assets. Some have been made available by large and growing derivatives markets where options, futures and swaps can be used to manage risk exposure.
Investment Choices
Some of the risk that a firm is exposed to is mitigated by the investment decisions that it makes. Consider retail firms like the Gap and Ann Taylor. One of the risks that they face is related to store location, with revenues and operating income being affected by foot traffic at the mall or street that a store is placed on.
Financing Choices
Firms can affect their overall risk exposure through their financing choices. A firm that expects to have significant cash inflows in yen on a Japanese investment can mitigate some of that risk by borrowing in yen to fund the investment. A drop in the value of the yen will reduce the expected cash inflows (in dollar terms) but there will be at least a partially offsetting impact that will reduce the expected cash outflows in dollar terms.
The conventional advice to companies seeking to optimize their financing choices has therefore been to match the characteristics of debt to more of the project funded with the debt. The failure to do so increases default risk and the cost of debt, thus increasing the cost of capital and lowering firm value. Conversely, matching debt to assets in terms of maturity and currency can reduce default risk and the costs of debt and capital, leading to higher firm value. What are the practical impediments to this debt matching strategy? First, firms that are restricted in their access to bond markets may be unable to borrow in their preferred mode. Most firms outside and even many firms in the United States have access only to bank borrowing and are thus constrained by what banks offer. If, as is true in many emerging markets, banks are unwilling to lend long term in the local currency, firms with long-term investments will have to borrow short term or in a different currency to fund their needs. Second, there can be market frictions that make it cheaper for a firm to borrow in one market than another; a firm that has a low profile
internationally but a strong reputation in its local market may be able to borrow at a much lower rate in the local currency (even after adjusting for inflation differences across currencies). Consequently, it may make sense to raise debt in the local currency to fund investments in other markets, even though this leads to a mismatching of debt and assets. Third, the debt used to fund investments can be affected by views about the overall market; a firm that feels that short term rates are low, relative to long term rates, may borrow short term to fund long term investments with the objective of shifting to long term debt later.
Insurance
One of the oldest and most established ways of protecting against risk is to buy insurance to cover specific event risk. Just as a home owner buys insurance on his or her house to protect against the eventuality of fire or storm damage, companies can buy insurance to protect their assets against possible loss. In fact, it can be argued that, in spite of the attention given to the use of derivatives in risk management, traditional insurance remains the primary vehicle for managing risk.
Insurance does not eliminate risk. Rather, it shifts the risk from the firm buying the insurance to the insurance firm selling it. Smith and Mayers argued that this risk shifting may provide a benefit to both sides, for a number of reasons. First, the insurance company may be able to create a portfolio of risks, thereby gaining diversification benefits that the self-insured firm itself cannot obtain. Second, the insurance company might acquire the expertise to evaluate risk and process claims more efficiently as a consequence of its repeated exposure to that risk. Third, insurance companies might provide other services, such as inspection and safety services that benefit both sides. While a third party could arguably provide the same service, the insurance company has an incentive to ensure the quality of the service.
From ancient ship owners who purchased insurance against losses created by storms and pirates to modern businesses that buy insurance against terrorist acts, the insurance principle has remained unchanged. From the standpoint of the insured, the rationale for insurance is simple. In return for paying a premium, they are protected against risks that have a low probability of occurrence but have a large impact if they do. The cost of buying insurance becomes part of the operating expenses of the business, reducing the earnings of the company. The benefit is implicit and shows up as more stable earnings over time.
The insurer offers to protect multiple risk takers against specific risks in return for premiums and hopes to use the collective income from these premiums to cover the losses incurred by a few. As long as the risk being insured against affects only a few of the insured at any point in time, the laws of averaging work in the insurer’s favor. The expected payments to those damaged by the risk will be lower than the expected premiums from the population. Consequently, we can draw the following conclusions about the effectiveness of insurance:
a. It is more effective against individual or firm-specific risks that affect a few and leave the majority untouched and less effective against market-wide or systematic risks.
b. It is more effective against large risks than against small risks. After all, an entity can self-insure against small risks and hope that the averaging process works overtime. In contrast, it is more difficult and dangerous to self-insure against large or catastrophic risks, since one occurrence can put you out of business.
c. It is more effective against event risks, where the probabilities of occurrence and expected losses can be estimated from past history, than against continuous risk. An earthquake, hurricane or terrorist event would be an example of the former whereas exchange rate risk would be an example of the latter. Reviewing the conditions, it is easy to see why insurance is most often used to hedge against “acts of god” – events that often have catastrophic effects on specific localities but leave the rest of the population relatively untouched.
Derivatives
Derivatives have been used to manage risk for a very long time, but they were available only to a few firms and at high cost, since they had to be customized for each user. The development of options and futures markets in the 1970s and 1980s allowed for the standardization of derivative products, thus allowing access to even individuals who wanted to hedge against specific risk. The range of risks that are covered by derivatives grows each year, and there are very few market-wide risks that you cannot hedge today using options or futures.
Futures and Forwards
The most widely used products in risk management are futures, forwards, options and swaps. These are generally categorized as derivative products, since they derive their value from an underlying asset that is traded. While there are fundamental differences among these products, the basic building blocks for all of them are similar. To examine the common building blocks for each of these products, let us begin with the simplest ––the forward contract. In a forward contract, the buyer of the contract agrees to buy a product (which can be a commodity or a currency) at a fixed price at a specified period in the future; the seller of the contract agrees to deliver the product in return for the fixed price. Since the forward price is fixed while the spot price of the underlying asset changes, we can measure the cash payoff from the forward contract to both the buyer and the seller of the forward contract at the expiration of the contract as a function of the spot price and present in it.
A futures contract, like a forward contract, is an agreement to buy or sell an underlying asset at a specified time in the future. Therefore, the payoff diagram on a futures contract is similar to that of a forward contract. There are, however, three major differences between futures and forward contract. First, futures contracts are traded on exchanges whereas forward contracts are not. Consequently, futures contracts are much more liquid and there is no default or credit risk; this advantage has to be offset against the fact that futures contracts are standardized and cannot be adapted to meet the firm’s precise needs. Second, futures contracts require both parties (buyer and seller) to settle differences on a daily basis rather than waiting for expiration. Thus, if a firm buys a futures contract on oil, and oil prices go down, the firm is obligated to pay the seller of the contract the difference. Because futures contracts are settled at the end of every day, they are converted into a sequence of one-day forward contracts. This can have an effect on their pricing. Third, when a futures contract is bought or sold, the parties are required to put up a percentage of the price of the contract as a “margin.” This operates as a performance bond, ensuring there is no default risk.
Options
Options differ from futures and forward contracts in their payoff profiles, which limit losses to the buyers to the prices paid for the options. call options give buyers the rights to buy a specified asset at a fixed price anytime before expiration, whereas put options gives buyers the right to sell a specified asset at a fixed price.
Swaps
In its simplest form, titled a plain vanilla swap, you offer to swap a set of cash flows for another set of cash flows of equivalent market value at the time of the swap. Thus, a U.S, company that expects cash inflows in Euros from a European contract can swaps thee for cash flows in dollars, thus mitigating currency risk. To provide a more concrete illustration of the use of swaps to manage exchange rate risk, consider an airline that wants to hedge against fuel price risk. The airline can enter into a swap to pay a fixed price for oil and receive a floating price, with both indexed to fuel usage during a period. During the period, the airline will continue to buy oil in the cash market, but the swap market makes up the difference when prices rise. Thus, if the floating price is Rs.1.00 per gallon and the fixed price is Rs.0.85 per gallon, the floating rate payer makes a Rs.0.15 per gallon payment to the fixed rate payer. Broken down to basics, a plain vanilla swap is a portfolio of forward contracts and can therefore be analyzed as such. In recent years, swaps have become increasingly more complex and many of these more complicated swaps can be written as combinations of options and forward contracts.
Picking the Right Hedging Tool
Once firms have decided to hedge or manage a specific risk, they have to pick among competing products to achieve this objective. To make this choice, let us review their costs and benefits:
- Forward contracts provide the most complete risk hedging because they can be designed to a firm’s specific needs, but only if the firm knows its future cash flow needs. The customized design may result in a higher transaction cost for the firm, however, especially if the cash flows are small, and forward contracts may expose both parties to credit risk.
- Futures contracts provide a cheaper alternative to forward contracts, insofar as they are traded on the exchanges and do not have be customized. They also eliminate credit risk, but they require margins and cash flows on a daily basis. Finally, they may not provide complete protection against risk because they are standardized. Unlike futures and forward contracts, which hedge both downside and upside risk, option contracts provide protection against only downside risk while preserving upside potential. This benefit has to be weighed against the cost of buying the
options, however, which will vary with the amount of protection desired. Giddy suggests a simple rule that can be used to determine whether companies should use options or forward contracts to hedge risk. If the currency flow is known, Giddy argues, forward contracts provide much more complete protection and should therefore be used. If the currency flow is unknown, options should be used, since a matching forward contract cannot be created. In combating event risk, a firm can either self-insure or use a third party insurance product. Self insurance makes sense if the firm can achieve the benefits of risk pooling on its own, does not need the services or support offered by insurance companies and can provide the insurance more economically than the third party.
As with everything else in corporate finance, firms have to make the trade off. The objective, after all, is not complete protection against risk, but as much protection as makes sense, given the marginal benefits and costs of acquiring it.
Conclusion
We began by looking at the process of risk profiling, where we outline the risks faced by a business, categorize that risk, and consider the tools available to manage that risk and the capabilities of the firm in dealing with that risk. We then move on to look at the costs and benefits of hedging. The costs of hedging can be explicit when we use insurance or put options that protect against downside risk while still providing upside potential and implicit when using futures and forwards, where we give up profit potential if prices move favorably in return for savings when there are adverse price movements. There are five possible benefits from hedging: tax savings either from smoother earnings or favorable tax treatment of hedging costs and payoffs, a reduced likelihood of distress and the resulting costs, higher debt capacity and the resulting tax benefits, better investment decisions and more informational financial statements.
While there are potential benefits to hedging and plenty of evidence that firms hedge, there is surprisingly little empirical support for the proposition that hedging adds value. The firms that hedge do not seem to be motivated by tax savings or reduce distress costs, but more by managerial interests – compensation systems and job protection are often tied to maintaining more stable earnings. As the tools to hedge risk – options, futures, swaps and insurance – all multiple, the purveyors of these tools also have become more skilled at selling them to firms that often do not need them or should not be using them.
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