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.

Companies Failing in ERM

After much discussion, companies have seen that ERM is one of the critical aspects of keeping a company running and efficiently. Primarily because it helps companies assess their exposure to risk and find ways to offset them. However, some companies are still failing in this particular area. KMPG LLP and their leading ERM leader, John Farrell, have pointed our three key areas where most companies lack in their ERM area.

They are:
1. Risk culture
2. Risk management processes
3. Technology.

To attack the first, companies are not being balanced in their risk culture. During a survey that KMPG conducted in 2008, they found that 58% of the companies they surveyed did not have a clue on how risk exposures should be assessed and 33% of the companies reported that they did not have a risk management training or teaching. This is a disadvantage because without proper knowledge (training) of how to first, minimize or avoid some risks in our daily work routines, and second, be able to properly handle activities with an exposure to risk, companies are setting themselves up for a failure. It's important for every member, management and lower level workers, to know the risk tolerance of that particular company. This will in turn help them develop risk management techniques to coincide with that level of tolerance they have.

For the second area, risk processes, the survey discovered that most companies are not doing a sufficient job of creating an accurate process to assess their risks. In fact, 33% said they do not even have a risk management process in effect, 13% said they have a risk process, and only 14% of companies have a governance (i.e. risk management committee). However, Farrell has stated that companies should be doing more. Committees and departments focused on this area is necessary for companies to stay in line with management and their risk tolerance. It's all a part of the never ending circle and connection between the top and bottom.

Lastly, companies are lacking in the area of technology. Only 25% of the surveyed companies have applied technology to their ERM area. Of course, this is a hindrance. In our society today, technology drives and aids essential activities. To better assess a company's risk, various systems aided with technology is necessary.

Overall, there is much that can be done to fix this problem. KMPG has listed a few key starting points.
"1. Get strategic: Align ERM to the company's strategic objectives to drive business value, taking into account the needs of all constituencies.
2. Rationalize and simplify: Establish a single-view of risk, with a common risk language (e.g., risk context and categories, evaluation factors [e.g., likelihood, consequence], treatment options and monitoring/internal auditing allocation) to be leveraged across the organization.
3. Consider "three lines of defense": Build upon a thorough "vertical" risk management structure with independence and clear accountability.
4. Formalize and standardize (with practicality): Create a sustainable risk management process (e.g., risk assessment, risk management and risk reporting).
5. Influence behavior through building competencies: Embed risk management competency in the business and operating philosophy.
6. Get proactive: Continuously improve the risk management and monitoring process to anticipate evolving market conditions and business objectives (e.g. risk quantification, risk appetite)."

It's not a process that will done overnight, but with much work and determination, it can and will be done. ERM will be done and done efficiently.

(The post above is a paraphrase of information found in the following source. All statistics are accurate according to the website. ALL information was provided by the source as well.

KMPG LLP. "Many Enterprise Risk Management Programs Lack Fundamentals, According to KPMG's Survey of Internal Auditors and Boards". The Earth Times. 20 January 2009. 23 January 2009 <http://www.earthtimes.org/articles/show/many-enterprise-risk-management-programs,685355.shtml>.)

CAPM

CAPM (Capital Asset Pricing Model) uses several assumptions in order to be used correctly. They are that "...all investors are:

Aim to maximize economic utility.
Are rational risk-averse.
Are price takers, i.e., they cannot influence prices.
Can lend and borrow unlimited under the risk free rate of interest.
Trade without transaction or taxation costs.
Deal with securities that are all highly divisible into small parcels.
Assume all information is at the same time available to all investors. " (By way of Wikipedia. http://en.wikipedia.org/wiki/Capital_Asset_Pricing_Model#Assumptions_of_CAPM)

The CAPM is also used to recognize the efficient frontier, portfolios consisting of two risky assets that fall on the upward sloping portion of the investment opportunity set (
The set of all attainable combinations of risk and return offered by portfolios formed using the available assets in differing proportions.) Along with other financial applications, an analyst can create the optimal portfolio that includes risky assets and non-risky assets that will give the investor an expected return according to his/her risk tolerance. (Anand V., Professor of Finance at Georgia State University. Spring 2008. Reference slides can be provided if necessary.)

Enterprise Risk Management

Enterprise Risk Management has been defined in a numerous amounts of ways. The CAS (Casualty Actuary Society) defines ERM as "…the discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization's short- and long-term value to its stakeholders." (Enterprise Risk Management Committee (May 2003). "Overview of Enterprise Risk Management" (PDF). p.8 Casualty Actuarial Society. By way of Wikipedia.org). However, for a person just hearing of the term, this definition can seem quite wordy and over the top. To me ERM is basically the process of companies discovering and analyzing company risks to ensure that future company actions are safe and profitable. In essences, companies are creating subset risk management groups to take into account all of the major risks that their company face and find ways to offset those risks. For example, UGG (United Grain Growers) of Canada implemented ERM in order to gain the main benefit, being able to "...make better decisions as a result of having a better understanding of the firm's risk." (Risk Management & Insurance. Harrington and Niehaus, p.592). Because of their decision to do ERM, UGG was able to recognize it's top 47 risks, take their top 6, fit a distribution to their data, and discover their main source of unmanaged risk (which happened to be weather). From this, they were able to go the next step, which is deciding which risk management procedure to choose.

In all of that, it's safe to say that ERM is critical aspect to all companies. Those who are slacking in this area or slow to even step up to the plate to begin this process are in a spot to be left behind and exposed to many risks. This subject is so important that even the SOA (Society of Actuaries) have created a new credential for this study. (The new title is CERA, Chartered Enterprise Risk Analyst. For those who want to know the requirements of this credential, visit http://www.soa.org/education/exam-req/edu-cera-req.aspx). Overall, ERM is proving to be an arena of study that will be quite beneficial to all companies.