Businesses and corporations will (and should) always seek to minimise risk. In the corporate world, the practice known as ‘hedging.’ In this article, we’ll explain what corporate hedging is and how it can help businesses minimise risk.
Corporate Hedging
Hedging is similar to taking out an insurance policy. For example, if you own a home in a flood prone 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 a flood from occurring, 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 trade-off within hedging; while it reduces potential risk, it also chips away at potential gains.
Challenges
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.
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.
2. Evaluate the costs of hedging vs. 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.
3. 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.
Conclusion
Hedging is a way to minimise risk, by reducing immediate rewards. 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.
