Risk Management

The idea of risk management is fairly new to corporations since 1980s, now managing risk has become paramount to corporation success. The practice of risk management has grown substantially over the recent years in not only the US, but around the world. Tools of risk management can include: currency swaps, foreign exchange contracts, interest rate options, interest rate swaps, and currency options. Reasons for this increase in use of tools for risk management include exchange and interest rate volatility, a new understanding of the practice, a greater emphasis on international companies.

Good ways to efficiently unbundle risk is to have the individuals that can handle them in a more stable manner. A risk that is not diversifiable but derivatives enable it to be less evident, is factor risk. Investors can also use hedging for individual use, and they may use derivatives to assist with systematic risk. The most influencial and frequent users of hedging are financial institutions and corporations.

The Modigliani-Miller Theorem tells us that without taxes and other frictions within the market, the "capital structure" rationale is not relevant[1]. This theorem shows why investors are on the fence about whether the firm hedges or they hedge themselves, by illustrating that investors themselves can leverage their portfolios. An investor will have the same factor risk whether a firm decides to hedge or not. So in frictionless markets there is nothing to be gained by the investor if a firm practices hedging. This theorem makes quite a few assumptions, because an individual investor most likely will not have as much access to hedging opportunities, and they may not have the expertise or experience that corporations would have. “Hedging is unlikely to reduce a firm’s cost of capital”, and since hedging does not gain a company by saving them money, it must “increase expected cash floes if it hopes to improve the firm’s value” [1].

It seems that there are various incidents that could have been prevented if companies would have just hedged their risks. One example is Continental Airlines; they were put out of business when fuel costs doubled. Hedging is almost necessary even if the shareholders are not influenced by the hedging decisions of the firm they are investing in. There are quite a few benefits with hedging which are lowering costs from financial distress, lower taxation, help evaluate leaders better, improvement of investment and operating decisions, and to help plan for capital needs.

The reasons many situations gain from hedging is costs associated with getting one less dollar of profit as opposed to one more is much more expensive for corporations. The “negative realizations exceed the benefits of positive realization [1]” in many cases since the realization for the positive gains comes at a price that there is inherent risk that the profit will be significantly lower than the expected amount. During tax hedging a firm will lose more money if it is taxed on higher amounts but if the same firm makes that much negative the next year the amount returned does not equal the amount paid out for inverse amounts of taxable dollars. This justifies the need to hedge taxable funds since the gain of not being taxed far outweighs the being taxed and hoping to not reach above the tax limit to receive all the funds back from the IRS.

Distress on a company can cause issues with the debt and equity holders, this distress can cost companies a significant amount of money [1]. There is many times a financial strain from having a reputation of being financially unstable as well. Hedging allows more debt to be taken because the routine payments from hedging cash flows are more stable than fluctuating cash flows which allows companies to be able to take out more debt because they know more about the cash flows they expect and can eliminate the risk that they will not be able to hold as much debt. Depending on what kind of cash flows are recognized by a firm, they may either invest or not on these funds, and may find them in trouble when cash flows are slow. Hedging allows those cash flows to even out and allow for a more constant flow of funds.

There are many circumstances that would make corporations not want to completely hedge their risks. These circumstances may be when a company makes much of their revenue when there is an upside to a commodity or a trade [1]. In these circumstances it is many times good to only partially hedge so they can realize the gain if it comes out, but they can also reap the costs they put in to either break even or maintain status quo and make a bit in the positive region.

Another reason to hedge as described in an earlier paragraph is the hedging for the purpose of the performance of the managers, and visibility to what work he/she is actually contributing [1]. This not only helps to keep a gage on the executives performance but it is also a very good incentive for managers to strive to make the actual factors they are able to influence be as favorable as possible.

In some cases there are reasons as to why a company would choose not to maximize corporation value; this presents a different challenge to hedging. Managers may have incentives to speculate, where they believe there will be positive returns if they just invest in the future of some commodity where they would be better off hedging their bets [1]. In this case there is a large probability that there may be extreme losses when ‘outcome betting’ takes place.

Hedging can benefit most companies, but these favorable outcomes differ accross companies. Financial distress can be a very key item to hedge especially if financial distruption is a possible outcome. There are also some select instances where a firm should not hedge, or partially hedge. Oil firms or firms that have more information than the public may find themselves not favoring a hedge position, but there may be a strong incentive to at least hedge a small amount to offset possible loss. Risk management should not be treated lightly as it is a strategic decision of a firm and is critical to be certain that all of the necessary risks are hedged adequately. As a manager it is important to understand why hedging is important and understanding the logic behind the idea, and it is equally important to understand that there are certain risks that are better left unhedged. The 20th century dictates that managers not only stay in connection with all of the decision processes available, but it also is forcing managers to actually know how to implement such practices.

[1] Grinblatt, Mark & Titman, Sheridan. "Financial Markets and Ccorporate Strategy" McGraw-Hill Companies New York 2nd Edition, NY. 2002.