Introduction
In a classic financial world as predicted by Modigliani and Miller (M&M), the risk management should be irrelevant. When there are no information asymmetries, taxes or transaction cost involved, hedging will not add any value to a firm because shareholders or companies can diversify their portfolio in such a way that their overall risk will be totally hedged (Lin and Chang 2006). However, the real world is far from the Modigliani and Miller model. In practice, we see imperfections in the financial market. This imperfection may actually create a rationale to reduce the volatility of earnings for a firm through hedging.
Many empirical studies have shown that hedging adds firm value in some cases. However, many other studies are inconclusive to predicate that hedging actually adds any value. The whole concept of hedging is to reduce the risk for a firm using various tools. While facing a risk, a firm has three choices to choose from. First, the firm can do nothing and just wait for the risk to pass on its own. Second, the firm or its owners can take some action against the risk by buying options and futures to hedge against specific risks or by buying insurance or fund assets in such a way that the risk exposure is reduced (Smithson and Simkins 2005). Finally, the firm can intentionally increase the risk exposure to acquire significant advantage over the competition. This essay will discuss whether or not hedging can add value to a firm.
Risk, Exposure and Categorization
Every business faces some risks or the other. Therefore, the first step taken towards mitigating the risk would be to make a list of all the risks faced by a firm. A firm is susceptible to many types of risks. For example, a coffee company, based in New York, which buys coffee beans from the farmers of Colombia, packages them in Florida and then sells them all over the US market through different types of stores may encounter several types of risks. First of all, a political trouble in Colombia can disrupt the supply of raw material. The packaging plant in Florida is susceptible to hurricanes and Tsunami for being situated near to the sea shore in Florida, which is a hurricane prone state. Furthermore, there is a risk of unionized employees going on a strike. The company also might face risk posed by its competitors that sell better coffee at a lower rate or get better deals because of higher volumes. Finally, there are risks lurking in the market as well. The overall demand for coffee may decrease if a considerable portion of customers switch to other competing drinks. The more we analyze the risk, the more complex they become. Thus, it is a good idea to broadly categorize risks than identify each one of them.
Risks can mainly be classified into five broad categories: 1) Market and Firm specific risks, 2) Operating and Financial risk, 3) External Event risk 4) Catastrophic risk and 5) Small risks (Smithson and Simkins 2005). We will mainly discuss the first two risks in this paper. The next two risks are generally mitigated by buying insurance. The last of the five risks is often not considered as important, and therefore, no hedging action is taken to mitigate that risk. However, the first two categories of risk are considered as the most common candidates for different types of hedging techniques. However, it is debatable whether those hedging techniques ultimately reduce those risks for the firm by increasing its overall value. As per the M&M model, the market risk can be mitigated if a firm expands itself into other business segments, but the cost of entering into a new venture and the low probability of success far outweigh the cost of risk in most of the cases (Damodaran 2008). Similarly, firm risks can be totally hedged by the shareholders through investments in diversified portfolios.
As per the M&M model, the risk will be totally mitigated for a perfectly diversified portfolio.
Looking at certain statistics of different firms, it may seem that hedging adds firm value. In 2010, there was a survey conducted among the US companies to find out how many companies use different hedging techniques. It was found out that almost all the companies use insurance as the basic hedging technique against the natural disasters and accidents (Berrospide and Punanandam 2011). Apart from that, almost 80% of the companies use some kind of hedging techniques like options, forwards and futures in stock, commodity and forex market to reduce the risk that comes from exposure (Smithson and Simkins 2005). Especially, one of the most common forms of hedging technique used by the airline and energy companies to reduce the risk of raw material (oil) price volatility is to buy put options (Jin and .Jorion 2007) That way even if oil price goes up beyond a certain point, they need to pay nothing more than a ceiling price. However, there is a cost involved for buying that option, and there is also a potential loss for the firm if the oil price remains lower than the ceiling price. In USA, most of the firms use hedging techniques. However Warren Buffet, in a memo to his employees, has blasted the practice of using derivatives as a measure to reduce risks.
There is a strong argument against hedging. The main form of risk exposure faced by a firm is often the exchange exposure. However, many argue that the exchange exposure is redundant to manage at a firm’s corporate level. It can be managed by the shareholders at individual level. Therefore, the corporate risk management is not a candidate for hedging as it does not add any value to the firm (Smithson and Simkins 2005). However, many proponents of hedging often suggest that systematic risks are the only risk that matters for firm valuation and that these risks can actually be reduced through the use of different hedging techniques.
There are several assumptions made in those above statements arguing for or against hedging. We will look at different benefits and costs of hedging in order to see if the benefits justify the cost.
Costs and Problems of Hedging
Protecting a firm from risks is not costless. Sometimes the cost of hedging is explicit (For example: buying insurance). However, buying futures and forwards have implicit costs (Damodaran 2008). These costs raise the old questions again as to when to hedge and when not.
Most of the companies insure against risks, and the cost of insurance is easy to calculate. This explicit cost directly provides the cost of risk protection. In this case, the trade-off is simple. The higher the protection against risks, the higher is the cost of insurance premium. It is a decision a firm needs to take as to how to secure itself against a risk. For example, a company based in Florida may opt for an exhaustive insurance against damages caused by hurricanes and floods. However, a company based in Ohio will not prefer paying high premiums to hedge against the risk of flood and hurricanes.
However, other hedge options are not as simple to calculate as insurance. There is no insurance available against the market risk, financial risk, operational risk and firm specific risks (Berrospide and Punanandam 2011). To reduce these risks, firms have used different techniques out of which ‘Option’ is the technique easier for understanding and is a more explicit measure of risk than others (Smithson and Simkins 2005). A company buying an option knows the cost involved in buying the option as well as the price guarantee. This part of the cost being explicit makes it easy for a firm to take the decision of buying an option. However, there is an implicit cost to option. The firm will not know today the actual price of the option for the future. If the actual price is unfavorable, then the price difference will bring a potential loss for the company. Similar is the case with futures and forwards. The use of any hedging tool costs money for the company. For the explicit tools, cost is reflected in the financial statement of the current period, and for the implicit tools, cost manifests its effect in subsequent periods (Damodaran 2008).
Value of Hedging to customers and shareholders
Shareholders are direct beneficiary of benefits from hedging. Hedging can only add value to the firm and shareholders if there are imperfections in the capital market. In case of a market which is perfect or nearly perfect the cost of hedging cannot justify the benefit thus shareholders do not gain anything. Shareholders may gain in many ways from hedging. If a risk hedging is done on earnings then shareholders can expect profit retained profit and increase of share capital. Also if a firm takes measure to reduce its distress cost or price volatility of the input materials then the risk for the shareholders also reduces by the same amount. However, there is an underlying assumption that the cost of buying the hedging tool is less than the benefit earned. If that is not the case then the firm will not gain any value and so does the shareholders (Berrospide and Purnanandam 2008).
Customers are impacted by hedging in an indirect way.
If a firm through the process of risk management increases firm value. Especially if the firm value is increased in terms of explicit capital flow then there is a chance that the extra earnings will be passed on to the customers as a way of reduced price. Customers will get the same product at a lower price from a firm which can increase tangible firm value through hedging. On the other hand, if a firm engages itself into too much risk management practices, then the overall cost for the firm may go up. In such cases the firm loses operating margin. Sometimes the firm may want to pass on that extra burden of risk management to the customers which may result in customers not benefitting from hedging of risk (Berrospide and Purnanandam 2008).
Benefits of Hedging and Can it Increase Firm Value?
There are some benefits of hedging. One of the most common benefits can be realized through tax benefit. A firm hedging against risk gains in terms of tax benefit than a firm that does no risk hedging (Damodaran 2008). Let’s take an example to illustrate the benefit. Suppose a firm has done risk hedging for the smoothing of earnings. The other firm faces earning volatility as it chooses not to hedge. Suppose the country they operate in has the tax rate of 30% on an income below $1,000 and 50% for an income above $1,000. The table below shows how one can gain by risk hedging the earning:
We can see that the total tax paid by the company who did not do risk hedging is $1850 whereas the company who did risk hedging on earnings actually had a much smoother earnings over the four year period and also paid less tax. Through the risk hedging, the overall saving over a period of four years is $140. This means that till the cost of risk for smoothing the taxable income is $140, it is beneficial to go for hedging.
Companies can hedge themselves against distress. The cost of bankruptcy is very high, and it is prudent for companies to hedge themselves against that cost. This will act as insurance of the investors’ money. The cost of distress can be calculated using the discounted cash flow valuation. The present value of a firm with hedging and without hedging should be calculated to see if it makes sense for the company to buy a hedging option against bankruptcy (Damodaran 2008).
Another benefit of hedging is improved capital structure. Closely related to the reduction of distress cost is the tax advantage that accrues from more debt capacity. Firms facing less distress cost are more likely to borrow more money if borrowing creates more tax benefit. Firms hedging away larger chunks of their risks can borrow more money and achieve a lower cost of capital. In such cases, the firm value will increase due to hedging (Berrospide and Punanandam 2011).
Hedging can force a company to take poor investment decisions. For example, the manager of a firm may find it difficult to take measures for risk reduction. Most of the managers’ compensation being related to the company earnings, if they want to reduce their firm specific risks, then there will be a cost associated with it which will reduce their compensation in the current period. As a result, managers may reject the investment options that may add value to the firm and may opt for hedging options that do not cost anything in the current period and do not add any value to the firm in the subsequent periods (Berrospide and Punanandam 2011).
Similarly, capital markets are also not frictionless. A company in order to reduce its financial risk should make plans for investment. However, in some cases, firms may not have adequate money to fund investments. These firms either issue stocks at a discount or raise funds from banks at a premium. In both the cases, the cost of risk mitigation goes up (Berrospide and Punanandam 2011). In most of the cases, it is seen that companies which have hedged their risk have sound financial and operating condition. On the other hand, risky companies do not get loan or sources of fund to invest in hedging activities, so either they underinvest in hedging or they don’t do hedging at all. In this case, although the market knows that hedging can reduce risk, still two distinct groups evolve. The first group has very low chances of default but still has a well-hedged portfolio. The second group faces high market and financial risk, but still cannot hedge the risk fully making their condition even riskier for the investors. Even if hedging tools are available in this imperfect market, they add no value to the firms that are in need.
Based on the above discussion, the whole ideas can be summarized in the below diagram to show in which cases hedging increase firm value and in which cases it doesn’t.
Hedging Practices among Real World Companies
There are a lot of firms across the world using different hedging techniques. It is seen that larger firms are more likely to use hedging than the smaller firms. Most of the companies mention their hedging activities in the financial statement explicitly. Hedging techniques are mostly used for reducing the risks of price volatility. Especially, most of companies hedge against their input and output cost volatility (Berrospide and Punanandam 2011). For example, it is seen that most of the gold mining companies, aviation companies and energy companies hedge using the technique of the future’s pricing (Jin and .Jorion 2007). The most of common form of hedging technique used by both small and big companies remains insurance. However, bigger companies use more complex tools like forwards, future and option techniques to reduce risks and increase firm value (Lin and Chang 2006).
In 2007, Southwest airlines along with some other airlines bought gasoline price futures to hedge against the oil price upward trend and volatility. Air France was one company which gambled on not hedging against the oil price. In next few years when the oil price went up due to problem in most of the oil producing middle-east countries. Southwest was immune to the price due to hedging and suffered less but Air-France made a huge loss due to increased price of the fuel. Similarly, Penny Cagan in her article have cited that many companies have tried to reduce their operational risk by putting money in hedge funds. Especially, the companies which have excess capital , like banks and other financial institutions ( for example: J P Morgan) have invested money in hedge funds without due diligence and risk assessment. The result was huge depletion of firm value in many cases after the financial turmoil of 2007-2008.
Recommendation on Picking the Right Hedging Tool and Conclusion
It is not always easy to pick the right hedging tool. Once a firm has decided to hedge against a risk, it will have to choose among the competing hedging tools. Forward contracts provide a complete risk-hedging against some typical types of risk like price volatility. Forward contract is designed to hedge that type of risk and is best in that (Damodaran 2008). However, the cost of forwards is higher than most other hedging options and should be bought only when the higher cost justifies the risk mitigation. Futures provide a cheaper option alternative to forwards. Futures also eliminate credit risk. However, futures are standardized and may not fully be able to mitigate a firm’s risk like the way forwards do. Options are mostly used to reduce the downside risk. The benefit of reduction in the down side risk must be weighed against the cost of buying an option (Damodaran 2008). Often companies get confused between whether forwards or options to be used for a particular type of risk. If the cash flow is known, then it is better to hedge using a forwards contract but if there is uncertainty over the currency flow then it is advised to use options for hedging.
There are certain benefits to hedging. There are also multitudes of examples that real world firms do hedge. However, there is very little or no evidence that hedging actually creates firm value. From a perfect world perspective, hedging is not required. However, the world is not perfect, so there is a need for risk mitigation. Hedging seems to be a tool that helps in mitigating risks and thus, increases firm value. We have seen above that the firms can save money through tax savings and price volatility reduction, if they use hedging in a proper way. However, in the real world, firms are not motivated to do hedging by tax savings or distress reduction. Managerial interests like compensation and job protection are the predominant factors that drive a firm towards hedging (Berrospide and Punanandam 2011).
Work Cited
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