Disadvantages of Hedging
There are some theoretical reasons for a firm not to hedge risk exposures but most of those reasons make the unrealistic assumption of perfect capital markets, which is not realistic. Also, they ignore the existence of the significant costs of financial distress and bankruptcy. However, in practice, there are some valid reasons not to hedge, including the distraction from focusing on the core business, lack of skills and knowledge, and transaction and compliance costs.
Advantages of Hedging
Many reasons exist for a firm to hedge its risk exposures. Key reasons include lowering the cost of capital, reducing volatility of reported earnings, operational improvements, and potential cost savings over traditional insurance products.
Hedging Methods
Hedging operational risks tend to cover a firm’s income statement activities while hedging financial risks tend to cover the balance sheet.
Pricing risk could be thought of as a type of operational risk, requiring the hedging of revenues and costs.
Foreign currency risk refers to the risk of economic loss due to unfavorable changes in the foreign currency exchange rate; to the extent that there is production and sales activity in the foreign currency, pricing risk would exist simultaneously.
Interest rate risk refers to the risk inherent in a firm’s net exposure to unfavorable interest rate fluctuations.
Hedging Strategy
Hedging strategies could be categorized as either static or dynamic, with dynamic strategies being more complex and requiring additional monitoring and transaction costs. Additionally, factors such as time horizon, accounting, and taxation need to be considered within any hedging strategy.
The board, together with management, should set the firm’s risk appetite using one or more of the following tools: qualitative statements of risk tolerance, value at risk, and stress testing. A firm must know its risk and return goals before embarking on a risk management plan. These goals must be clear and actionable.
In hedging specific risk factors, it is necessary to consider the role of the board of directors as well as the process of mapping. There should be clarification whether accounting or economic profits are to be hedged. Likewise, there should be clarification whether short-term or long-term accounting profits are to be hedged. Other points the board should consider include the time horizon and the possibility of implementing definitive and quantitative risk limits.
Mapping risks requires clarification as to which risks are insurable, hedgeable, noninsurable, or nonhedgeable. Mapping risks could be performed for various risks such as market, credit, business, and operational. Essentially, it involves a detailed analysis of the impacts of such risks on the firm’s financial position (balance sheet) and financial performance (income statement).
Risk Management Instruments
Once the risks are mapped, management and the board need to determine which instruments to use to manage the risks. The relevant instruments can be classified as exchange traded or over the counter (OTC). Exchange-traded instruments are generally quite standardized and liquid. OTC instruments are more customized to the firm’s needs and therefore less liquid. An element of credit risk is also introduced with OTC instruments.
