Motivations For Hedging

Firms hedge for several reasons. One major reason is to reap tax benefits. Losses and profits are taxed asymmetrically. For example, $100 million profit will require a firm to pay approximately $35 million in taxes. On the other hand, if a firm experiences $100 million loss, they will only be eligible for a rebate up to the amount of taxes paid the two years prior to this loss. When looking at the two scenarios, the firm will lose more value from the $100 million loss than it would potentially gain from the $100 million profit. The two do not offset each other and through hedging, firms may reduce their potential tax liabilities.

Another reason for hedging is to avoid costs associated with financial distress. There are many costs associated with financial distress that result from its affect on the firm's stakeholders. Distress can cause conflict between debt and equity holders. It can also cause the firm's credibility and relationships with suppliers, customers, etc. to weaken, making it hard for the firm to conduct business. As a result, firms often hedge currency risk, in order to avoid potential financial distress. For example, if a U.S. firm is most valuable when its competitor's currency, the Japanese yen, is strong, the firm might want to hedge when some of this currency risk. If the firm sells forward or futures contracts on the yen, it will bet that the yen will weaken relative to the dollar. This will increase the value of the firm in situations where its value would typically decrease. The same way, the firm is able to ensure that it will be able to pay back its debts in different scenarios, thus avoiding the cost of bankruptcy. One important thing for firms to consider, however, is the cost of hedging and the degree to which hedging reduces variance in cash flows. If hedging costs are large or if it does not have a significant effect on the variance of cash flows, hedging may increase the potential for financial distress.

Firms that are able to utilize hedging to decrease their risk of financial distress, they may be able to take advantage of highly leveraged capital structures. By increasing the amount of debt financing that they are able to take on, firms will benefit from tax advantages as well as the lower costs associated with debt financing.

Firms that hedge are also better able to plan for capital needs. Some firms prefer to finance investment and R&D with internal sources of equity to take advantage of tax benefits and lower transaction costs. Investment expenditures corresponds closely to the firms cash flows, and as a result, firms too frequently over or underinvest. If a firm can take advantage of hedging to stabilize cash flows, it can better plan investments and increase the firm's value.

The next reason for hedging is to allow firms to develop better executive compensation contracts. Compensation should take into consideration risks that mangers control, but not risks that are outside of executive control. Managers compensation should be based on things such as cost cutting, but not interest rates. Profits may increase or decrease through changes in exchange rates, which has nothing to do with the manager's performance, and therefore, the manager should not be rewarded or penalized for such things that are out of their control. Through hedging, the firm is able to reduce the risks associated with interest and exchange rate fluctuation, allowing mangers to be compensated appropriately, giving them incentive to hedge. This also allows for better evaluation of performance.

Finally, hedging improves decision making. Through hedging, firms profits are less volatile, providing manager's with better information when making capital allocation decisions. Firms that analyze their costs with futures prices are able to determine whether or not they should increase or decrease production.

One final note on hedging looks at insurance. When deciding to hedge through insurance, a firm must consider information. If a firm believes that it has better information and is better able to assess risk, it is often costly to insure against such a risk. Insurance companies, in this situation, often overcharge. On the other hand, when insurance companies are better able to gauge risks and present value of losses, firms are more likely to use insurance.