Companies have become aware of how fluctuations in economic and financial variables can have a destabilizing effect on their performance. More and more companies are using derivatives markets to insulate themselves against macro risks.
The growth in derivatives trading has mainly come from companies. A large part of this growth is due to innovations by financial theorists, sic as Black-Scholes option-pricing formula, to value derivatives.
However, the theorists insights provide little guidance to management when it comes to risk management decisions. What is the goal of risk management?
If a company takes positions in derivatives that does not fit well with the overall strategy, it can result in major losses. The goal of the article is to present a framework to guide managers in the risk-management strategy.
The risk-management framework rests on three principles:
1. Corporate value comes from making good investments
2. Good investments depend on generating enough cash internally to fund those investments
3. Cash flows can be disrupted by external movements in exchange rates and commodity prices, compromising the company's ability to make good investments
The goal of a risk-management program is to ensure that the company has enough cash available to make valuable investments.
With this goal in mind, it becomes easier to identify the basic question of risk-management: which risks should be hedged?
FROM PHARAOH TO MODERN FINANCE
In the old testament, the pharaoh hedged the risk of bad harvests by storing corn. In the middle ages, hedging was made easier by futures markets. Consumers could ensure availability and price by buying crops for delivery at a future date.
Today, most new financial products are designed with corporations hedging needs in mind. It is however not as clear why a large public corporation would like to hedge since investors can hedge on their own.
Modigliani and Miller famously argued that value in a company is created by its assets, not its liabilities. When companies make good investments, they create value. How they finance those investments is irrelevant.
The postmodern paradigm accepts the key insights of M&M - that value is created by making good investments - but go on to argue that financial policy is critical in enabling these investments.
The key here is that different financing comes at different costs, also known as the pecking order theory. Because of information costs, equity is more costly than debt, and debt is more costly than retained earnings. Companies that can finance their investments with retained earnings will have a lower cost of capital. This lower cost of capital makes more investments profitable.
The pecking order theory forms the basis for the view stated earlier; financial policy is critical in enabling profitable investments.
WHY HEDGE?
An international company has exchange rate risk and a fixed investment target. The company is also too leveraged to borrow more, so retained earnings is the only financing source. Fluctuations in the exchange rate can therefore have an important effect on their ability to invest, either leaving them with too much or too little capital.
By eliminating the risk of not being able to invest, hedging the currency risk will increase the company's value. In general, the supply of internal funds does not equal the investment demand of funds. Hedging allows the company to conserve their valuable internal capital.
WHEN TO HEDGE – OR NOT
In the previous example we assumed that the demand of funds is not correlated with the availability of funds. In many cases, exchange rates, commodity prices or interest rates do affect the value of a company's investment opportunities.
An oil company's main risk is the price of oil. When oil prices rise, so does the firm's cash flows. But when oil prices increase, so does the available investment opportunities. This reduces the need for hedging, in fact, hedging too much of oil risks can lead to the company not having enough retained earnings during peak prices to invest fully.
A proper risk-management strategy ensures that companies have the cash when they need it for investment, but it does not seek to insulate them completely from tis of all kinds.
This approach helps managers address two key issues. (1) What is worth hedging and what isn't. Stock price volatility in itself is not the goal, individual investors can hedge or diversify this risk themselves. Investment volatility however, is worth controlling through risk management. (2) This approach helps managers decide how much hedging is necessary.
Managers should ask two questions: (1) How sensitive are cash flows to external risk variables, and (2) how sensitive are investment opportunities to those risk variables.
GUIDELINES FOR MANAGERS
1. Companies in the same industry do not necessarily have the same hedging needs. Companies in the same industry are exposed to the same external risk variables, but the sensitivity of their investment opportunities may vary.
2. Companies may benefit from risk management even if they have no major investments in plant and equipment. For companies that don't have plants to put up as collateral, internal funds are even more important.
3. Even companies with conservative capital structures – no debt, lots of cash – can benefit form hedging. Managers with a large cash cushion should ask themselves why they have a conservative capital structure. If the answer is to protect themselves from risk, they might reap tax benefits from taking on more debt and using derivatives instead to protect themselves.
4. Multinational companies must recognize that foreign-exchange risk affects not only cash flows but also investment opportunities. If a US company is investing in plants in Germany, and selling the products there, they need to hedge their exchange rate risk to maintain the same level of investments regardless of fluctuations.
If the same company is selling the cameras produced in Germany in the US, their investment opportunities will fluctuate with the exchange rate. The value of a new plant declines with a higher exchange rate as the demand for the cameras in the US will drop due to the higher price in US dollars.
5. Companies should pay close attention to the hedging strategies of their competitors. If a camera competitor that doesn't hedge is also considering building plants in Germany, but find themselves cash-strapped, the investment opportunity is even greater because of reduced capacity.
In this case, the investment opportunities depend on the overall structure of the industry and on the financial strengths of its competitors.
6. The choice of specific derivatives cannot simply be delegated to the financial specialists in the company. Management must be aware of the cash-flow implications of hedging instruments. Exchange traded derivatives that must be marked to market may require additional collateral, cutting into the company's cash flow. Secondly, the type of derivative must be considered (linear or non-linear).
The decisions of which contracts to use should be driven by the objective of aligning the demand and supply of funds within the company.
In conclusion, managers cannot ignore risk management, and risk management decisions cannot be delegated to financial staff. The risk management strategy must be aligned with broader corporate objectives with the goal of making good investments.
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