To Hedge or Not to Hedge?

One of the main reasons that derivatives markets are exceptionally successful is that they are a magnet for many different types of traders and are outstandingly liquid. When an investor wants to take a specific position for a particular contract, there is normally no problem in finding another investor willing to take the opposite position. The three broad categories of traders are hedgers, speculators and arbitrageurs. Each category uses derivatives for different reasons, which ultimately creates the high liquidity in the derivatives market.

What Hedge Funds Do

Hedge funds have become major users of derivatives for managing the expected risk from potential future movements in a market variable. Unlike mutual funds, it is not compulsory for hedge funds to register under the US federal securities law. As they do not go public, hedge funds are not subject to regulations and accept funds from savvy investors. Moreover, they have the freedom to develop sophisticated investment strategies to evaluate the risk that the funds are exposed to, decide on the acceptable risks and the risks that should be hedged and craft strategies using derivatives to hedge the unacceptable risks.

Basic Principles of Hedging

Hedging aims at eliminating the volatility or variance of enterprise value that involves a company's "market cap plus preferred shares, debt and minority interests minus total cash and cash equivalents." Since value is derived by discounting expected future cash flows at the required rate of return, only two factors can justify an increase in value: 1) an increase in expected cash flows or 2) a decrease in the required rate of return, which means less risk undertaken.

Many organizations use the derivatives market as a tool to enhance the expected future cash flows and reduce or eliminate risk related to a particular market variable including the price of oil, a foreign exchange rate or any other variable. This explains why many of the participants in the derivatives markets are hedgers. Most hedgers aim for a perfect hedge which perfectly eliminates the risk. However, as perfect hedges are quite unusual, hedgers formulate appropriate strategies so that hedges are as perfect as possible.

Why Organizations Should Hedge

There are many reasons why organizations should hedge to reduce or eliminate risk. Particularly businesses that are in the manufacturing or retailing sector and lack the expertise to predict the interest rates and the commodity prices should use hedge to reduce risks associated with these variables as they arise. This allows them to focus on their main business activities and be profitable.

In particular, the arguments for hedging are the following:

1. Hedging reduces financial distress

If an organization is in financial distress, the shareholders will be reluctant to provide additional equity for funding value-adding projects because part of the added value will go to the creditors. This causes an underinvestment problem. By reducing the volatility of expected future cash flows, hedging reduces or eliminates financial distress and increases value. This reduces or eliminates the risk of suboptimal investment decision-making.

2. Hedging increases borrowing capacity

By reducing the volatility of enterprise value, more creditors are willing to provide debt to the organization. Although, additional debt financing creates value only if it is the only way to fund projects with positive net present value (NPV), hedging increases the borrowing capacity of an organization due to efficient risk management.

3. Hedging dilutes asymmetric information

If an organization experiences volatility in earnings, shareholders cannot know if this volatility is due to financial risks that could be hedged or caused by ineffective managerial decision-making. Given that shareholders and management do not share the same amount of information and that organizations have superior information about financial risks that could be hedged, hedging dilutes asymmetric information. If shareholders see steadily growing profits and dividend management policies they have more faith in the organization, although they have not the same knowledge of financial risks.

4. Hedging anticipates risk aversion

Increased volatility in corporate value affects the organization's ability to conduct normal business in several areas including trade credit, customer satisfaction and employee retaining. By reducing volatility using hedging, managers anticipate their risk aversion. Moreover, hedging makes not only shareholders, but also stakeholders feel more comfortable, including employees, customers, suppliers and the broader community that the organization does business with.

Why Organizations Should Not Hedge

Although there are arguments in favor of hedging, there are both theoretical and practical reasons that organizations do not hedge.

First of all, in regards to financial distress, although the shareholders are reluctant to provide additional equity for funding value-adding projects, being in financial distress increases the volatility of the assets. This means that shareholders benefit from the upside variation while lenders undertake the downside risk. These circumstances might deter shareholders from hedging.

Secondly, shareholders are better able than organizations to diversify portfolio risk. An investor's well-diversified portfolio may be unaffected by the financial risks faced by an organization. If investors are better equipped with the skills and expertise to hedge on their own, they should do so. Moreover, if organizations are acting in the best interest of their well-diversified shareholders, hedging is, most of the times, unnecessary.

Thirdly, there is an issue with diversifiable risks in the financial markets. The standard model used to explain the relationship between risk and return, Capital Asset Pricing Model (CAPM), considers the risk free rate (r) plus a risk premium to determine the required rate of return and the beta (b) of each asset to determine the systematic risk, which, however, cannot be removed by diversification. Therefore, hedging changes neither the expected future cash flows nor the required rate of return if the risks being hedged are diversifiable.

In conclusion, Corporate Finance theory models the real world and attempts to determine the added value of hedging in a definite way. Although it makes sense to reduce the volatility of value or the variance of the expected future cash flows by hedging risks in the derivatives markets, theories are not conclusive. Hedging does add value provided financial market risks are not diversifiable. Hedging does add value to an organization that has more debt than equity. These principles should be taken into consideration when evaluating the added value of hedging. Therefore, finance managers and CFOs should not only understand theory, but also its limitations.

Sources:

http://www.investopedia.com/terms/e/enterprisevalue.asp

http://www.mafc.mq.edu.au/~dadams/CorporateHedging.pdf

Hull , J.C. (2005). Options, Futures and Other Derivatives (6th Edition), Prentice Hall

http://www2.gsu.edu/~fncgdg/material/FM-GAYNAM.pdf