4 Step Guide to Corporate Hedging
Want to find out more about corporate hedging, the risks involved and the tools? Click here for an in-depth 4 step guide.
The issue of whether or not to “hedge” continues to baffle many corporations and individuals. At the heart of the confusion are misconceptions about risk, concerns about the the cost of corporate hedging, and fears about reporting a loss on derivative transactions. A lack of familiarity with tools and strategies further creates confusion. This article plans to clarify the tools and strategies used to manage it.
What is Corporate Hedging and how does it work
Hedging is similar to taking out an insurance policy. For example, if you own a home in a flood zoned area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. This demonstrates that there is a risk reward tradeoff within hedging; while it reduces potential risk, it also chips away at potential gains. Essentially, hedging is not free. If you have further questions relating to how corporate hedging works, it is recommended you head to “How To Start A Hedge Fund”.
The Challenge of Corporate Hedging
An effective hedging program does not eliminate all risk. Rather, it attempts to transform unacceptable risks into an acceptable form. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging.
Step 1: Identify the risks of Corporate Hedging
These risks will generally fall into two categories: operating risk and financial risk. For most non-financial organisations, operating risk is the risk associated with manufacturing and marketing activities. This contrasts to financial risk, which is the risk a corporation faces due to exposure to market factors such as interest rates, exchange rates and stock prices. In determining which risks to hedge, the risk manager needs to distinguish between the risks the company is paid to take and the ones it is not. Ultimately, determining such risks will allow you or your company to take risks associated with your primary business activities.
Step 2: Eliminate the hedging stigma
The common belief is that hedging with derivatives introduces additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks.
Step 3: Evaluate the costs of hedging versus not Hedging
Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company suffers if market factors – such as interest rates or exchange rates, move in an adverse direction. Essentially, in such cases the cost of hedging must be evaluated in the same manner of an insurance policy.
Step 4: Understand your Hedging tools
A factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options. These consist of:
- Fowards: Swaps, Futures, FRAs, Locks.
- Options: Caps, Floors, Puts, Calls, Swaptions.
A well-designed hedging program reduces both risks and costs. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilising earnings. Should you have any further questions, it is recommended you head over to Corporate hedging, investment and value publication by the Federal Bank.
Alex currently works in the content team as a Legal Tech Intern for Lawpath. He has finished his Bachelor of Commerce (Professional Accounting) and is currently undertaking his last year of Bachelor of Laws at Macquarie University. His passion resides with commercial, corporate and tax law.