Hedging: Additional Value or Not?

Hedging is a concept that companies have heard of and implemented for years. Some have argued that it adds value for a company, while others would oppose and say it is a nothing more than speculation with more purpose. In any case, there proven benefits, as well as consequences, of hedging. Here, we'll give you both and potential reasons of taking up this strategy.

First, we can define hedging. According to Campbell Harvey (Professor of International Business at the Fuqua School of Business, Duke University), hedging is "a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory." In other words, a way for companies to reduce risks on their commodity through the use of various derivatives (this term to be explained in another posting). Well, some believe that hedging is a fancy operation of speculation. This isn't necessarily correct. Some financial strategies that firms implement can be hedging with a speculative component; however, the key difference lies with the ownership of the underlying asset. Hedging is when firms use derivatives to minimize risk of an asset that they own, while speculation is using these derivatives on assets you do own or plan to obtain. You are using these strategies for pure profit making.

Does hedging truly add value? For companies that use correct strategies for their firms, yes!
"Hedging can be optimal for a firm when an extra dollar of income received in times of high profits is worth less than an extra dollar of income received in times of low profits." However, if firms implement the wrong derivatives for hedging strategies, the benefits might not beat the consequences. For example, American Barrick is a gold mining company. During a time that gold prices were decreasing, the firm wanted to be protected against the risk of profit loss. To do this, they shorted some forwards contracts. (Forwards will be explained in great detail in the "Derivatives" posting). In summary, they entered into a contract that allow them to agree upon a price to sell their gold in the future. This allowed them to be able to sell gold at the agreed upon price, even if prices fell. However, when the price of gold began to rise gain, American Barrick lost out on the opportunity to gain more profits. Of course, after seeing this consequence, the firm reevaluated their strategy and implemented new plans, ranging from collars to spot deferred contracts. In general, for a producer to make great hedge moves, they could:

1. sell a forward (pros-lock in price just in
case
of price decline, cons-miss out on profits if price increased)
2. sell a call (pros-reduces loss through
premiums
collected, cons-places a cap on profits)
3. purchase a put (pros-provides a floor for
losses and allows firm to gain
profits from price increase, cons-have to pay
premiums)

All of these are potential ways of hedging for the producer of the commodity. Now, we'll explain some key reasons one should hedge.

1. Taxes - there are certain rules and regulations regarding taxes that companies must abide by as well as apply to their profits. However, the use of derivatives can alter some of those outcomes. For various areas of the tax code, derivatives can 1) equate present values of the effective rates applied to losses and profits, 2) defer taxation of capital gains income, 3) shift income from one country to another, and 4) convert one form of income to another.

2. Bankruptcy and distress costs - A large financial loss to a firm can be burdensome to the company and its potential to operate. With that in mind, chances of bankruptcy increase as well as the costs associated with it. Hedging can allow the firm to reduce the probability of going bankrupt and the costs of doing so.

3. Costly external financing - Related to the note above, when a company suffers a financial loss, it still hurts the firm even if they do not go bankrupt. The loss still has to be taken care of, whether through reserves or at the expense of investors. By having to use money to cover the loss, firms miss out on the opportunity of great investments. Hedging can protect those reserves while reducing the probability of having to raise funds from outside the firm.

4. Increase debt capacity - It was once said that you need to borrow money the most, that's the time that lenders won't give it to you. For firms, it's the same thing. If there is a higher chance of bankruptcy, lenders are not as lenient on lending the firm money. The use of hedging strategies can help firms reduce the risk of their cash flows, thereby making them seem less likely to go bankrupt, and capable of receiving loans.

5. Managerial risk aversion - Some companies are ran by managers who's compensation is closely tied to the riskiness of the firm. To protect their own assets, managers will operate in a way that makes the financial well being of the company more certain. This is done through hedging.

Now, hedging does not only come with benefits. There are some reasons why companies choose not to hedge. I mean, there had to be, otherwise every firm would be using derivatives.
1. Having to pay transaction costs (the cost of dealing with derivatives), such as commissions and the bid-ask spread.
2. Firms must be able to assess costs and benefits of their chosen strategies, which could require outside and expensive expertise.
3. Firms must monitor transactions and have managerial controls in place to prevent unauthorized training.
4. Although hedging comes with some tax advantages, firms still have to be prepared for other tax and accounting consequences of their transactions.

All in all, hedging can be seen as a safeguard. Although no particular strategy is perfect, the use of hedging can create value for firms, pending they use the correct derivatives. If hedging is not necessary or will be more costly to do so, than that firm should refrain from it. However, if it can be seen that a firm can gain more profits and limit their loss by implementing such strategies, then hedging is the way to go!

Sources:
1. Harvey, Campbell. "Futures". Duke.edu. 16 November 1995. 29 January 2009 <http://www.duke.edu/~charvey/Classes/ba350/futures/futures.htm>. By way of Wikipedia. <http://en.wikipedia.org/wiki/Hedge_(finance)>.

2. McDonald, Robert. "Introduction to Risk Management." Derivatives Market. 2006. Boston: Pearson Education Inc. p.91-120.