Risk And Hedging

Factor risk, although non diversifiable, can be hedged whereas firm-specific risk is generally diversifiable, not easily hedged, and is often insurable against. The Modigliani-Miller theorem states that cost of capital is determined by the business of the firm and not the firm’s debt or financing. The overall cost of capital does not change the firm’s value.

Reasons for risk management
• Tax implications
• Avoid financial crisis such as bankruptcy
• Planning for capital needs
• Increase the quality of investment and operational discussions
• Better management of executive compensation packages

Tax Implications
Gains and losses are treated asymmetrical. Losses result in a rebate of the amount of taxes the firm has paid in prior years. Simiarily, losses can be carried forward to offset future profits.

Avoiding Financial Crisis
Customers and suppliers are often reluctant to do business with firms facing bankruptcy. Additionally, financial crisis may cause conflicts between debt and equity holders.

Planning for Capital Needs
Delaying projects is costly for the firm. Internal capital when available is less costly for the firm than external capital. Planning is important to firms with high research and development expeditures.

Improved Decision Making
Higher quality decisions reduce profit volatility and known future prices can help the firm allocate capital. Additionally, insurance premiums are outstanding risk measures.

Executive Compensation Packages
Executive compensation packages can be structured to expose management only to controllable risks therefore minimizing risk exposure to uncontrollable risk.

Risk management within a firm may be centralized or divisional. Centralized risk management can help minimize the risk of trading as business unit expenses can be netted. Centralized risk management is helpful in firm’s lacking divisional expertise and is less costly than divisional risk management. Divisional risk management provides better evaluation of managerial performance and provides available specific risk information.

Speculation, the attempt to gain more significant returns based on knowledge, should only be attempted when management has access to private strategic information. Firms should be careful to avoid executive management compensation packages which may encourage excessive speculation.

Hedging is a mechanism to reduce risk. Larger firms, growing firms, highly leveraged firms, and firms with high price volatility such as agricultural and extractive industries tend to hedge more often. Factor risk can be hedged, whereas firm-specific risk cannot be hedged.

Arbitrating is the attempt to earn more than the risk free interest rate without taking additional risk.

Foreign Exchange Risk
Transaction Risk can occur a USA domiciled firm agrees to accept payment for its product in yen. Translation Risk can occur when a British domiciled firm opens a subsidiary in France. Economic Risk can occur when a local call center faces competition from a call center located overseas. Interest Rate Risk can occur when a US domiciled homeowner defaults on an adjustable rate mortgage as interest rates soar.