In a world full of uncertainty, every corporate needs a hedge

Protecting the bottomline against potential downsides is important

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Chiragra Chakrabarty & Ankan Mondal

There is an intriguing debate in both academic and industry circles on whether corporations should hedge.

The overbearing dilemma is whether this exercise adds value to shareholders’ wealth. Is it an economic activity on the part of the treasury of the company? What are the costs involved and do the benefits outweigh the costs?

In an attempt to understand the volatility of the underlying asset and its impact on shareholder value, finance administrators and portfolio managers try to reduce the volatility from future cash flows.

What they do understand is, even if the company operates in its homeland, the financial statements reflect the effects of global economic forces. This is because they have exposure to fluctuations in all kinds of financial prices.

Financial prices include foreign exchange rates, interest rates, commodity prices and equity prices. These variables are ‘stochastic’ in nature, meaning they are random variables and hence unpredictable.

Though we have advanced statistical tools like Monte-Carlo Simulators to forecast these variables, heavily relying on them is not recommended.

Yet, the effect of changes in these prices on reported earnings can be overwhelming.
This calls for introduction of financial re-engineering strategies using derivative products to mitigate these risks.

A few years ago, there were few takers for derivative products in India. Today, however, a lot of attention is being given by the same set of managers to the opportunities derivatives offer and how they could transform future cash flows, making them a necessary part of corporate treasury operations.

One way of reducing the exposure to random variables is to review the risk appetite of the corporation and lay down crystal clear objectives for hedging.

Hedging means entering into transactions in the financial and commodities markets, designed to reduce volatility or variance, on the cash flows. Since value is created by discounting expected future cash flows at a required rate of return, this increase in the value to the enterprise must come from either an increase in the expected cash flows or a reduction in the required rate of return through risk reduction.

Through hedging, the company enters in transactions, whose sensitivity to changes in financial prices offsets the sensitivity of its core business.

But, hedging is not simple, nor is it a concept that is easy to pinion. Hedging objectives vary widely from firm to firm, even though it appears to be a fairly standard problem across all enterprises. To top it up, the spectrum of hedging instruments available to the corporate treasuries is becoming more sophisticated with each passing day.

More importantly, hedging is contingent on the preferences of the company’s stakeholders.

Recent surveys show that corporations trading derivative products have been able to achieve an enhancement of cash flows and appreciating the value to the shareholders.

Along with appreciation of shareholder value, hedging could improve or maintain the competitiveness of a company. Companies having mature treasury divisions, recognise that the financial risks thrown up by their business ventures present a powerful opportunity to add to their cash flows while prudently positioning the firm so that it is not snipped by movements in the economic variables.

Let us assume there are two automobile manufacturers, producing similar products. If the price of galvanised steel used by them for making hatches and doors increases, the manufacturers have the option of either absorbing it on their financial statements or passing it on to the consumer by way of increased prices of the end product.

In such a situation, if one of the automotive makers is hedging in steel or zinc, it automatically retains the edge over the other automaker. In the long run, this would prove sustainable for the automaker who is hedging.

Peer group also places substantial pressure on the passive participants to become more advanced in risk management strategies or face the possibility of being priced out of the markets. Companies with sound risk management policies can use this stability to reduce their cost of funding or to lower their prices in markets deemed to be strategic.

True, we have had instances like Barings, Merrill Lynch, Proctor & Gamble, Caterpillar and more recently SocGen losing money using derivative products, but derivatives are not the devils of the treasury. Things took a difficult turn in these cases because these organisations lost control of their hedging objectives.

The management of risk is both difficult and conceptually challenging. Particular reference can be made to the issue of identifying the source and measuring the degree of risk. Consider a Mexican metal producer who borrows in US dollar as a partial hedge because their product is priced in US Dollar worldwide. The problem with this ‘hedge’ is it actually increases the risk.

The Mexican Peso is a commodity currency and when the metal prices fall, the Peso would be weaker. This means the exporter ends up paying a higher interest rate in Peso terms at a time when the revenues are decreasing.

The problem with this particular arrangement is that they failed to identify the correlation between metal prices and the Peso-US dollar exchange rate.

The issues encountered while designing a hedging policy are achieving a balance between uncertainty and the risk of opportunity loss. It is in the establishment of a balance that we must consider the risk aversion and the preferences of the stakeholders.

But identifying the pay-off from uncertainties and the risk of opportunity loss by the risk managers at the treasury division poses a problem of adverse selection. It is thus advisable for the corporate to appoint a third-party consultant, who would take on a non-aligned view of the market to identify, evaluate and validate the risk management policies of the firm.

Sometimes, treasury managers are inclined not to hedge. “Why hedge when the risks can be diversified in an efficient market?” they ask, assuming that the risk premium is determined by the covariance of asset return with the return of the market and no other risk matters.

Some also assume that hedging is not going to adjust future cash flows and try to achieve the hedged price as the expected price. That’s hedging, too. So if a steelmaker believes it has the skills to add value to the bottomline by trading steel, rather than producing it, it could do just that.

Hedging is not just about going ‘long’ or ‘short’ on a forward or futures contracts. It is also not about scripting the term structure of a swap agreement. Hedging is about making the best possible decision, integrating the company’s attitude towards risk and returns, systems and the preferences of their stakeholders.

The authors are with the PriceWaterhouseCoopers (India) LLP and can be reached at chiragra.chakrabarty@in.pwc.com and ankan.mondal@in.pwc.com, respectively. Views are personal.