Page 125 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes foreign exchange rates, interest rates, commodity prices and equity prices. The effect of changes
in these prices on reported earnings can be overwhelming. Often, you will hear companies say
in their financial statements that their income was reduced by falling commodity prices or that
they enjoyed a windfall gain in profit attributable to the decline of the Canadian dollar.
One reason why companies attempt to hedge these price changes is because they are risks that
are peripheral to the central business in which they operate. For example, an investor buys the
stock of a pulp-and-paper company in order to gain from its management of a pulp-and-paper
business. She does not buy the stock in order to take advantage of a falling Canadian dollar,
knowing that the company exports over 75% of its product to overseas markets. This is the
insurance argument in favour of hedging. Similarly, companies are expected to take out insurance
against their exposure to the effects of theft or fire.

By hedging, in the general sense, we can imagine the company entering into a transaction whose
sensitivity to movements in financial prices offsets the sensitivity of their core business to such
changes. Hedging is not a simple exercise nor is it a concept that is easy to pin down. Hedging
objectives vary widely from firm to firm, even though it appears to be a fairly standard problem,
on the face of it. And the spectrum of hedging instruments available to the corporate Treasurer
is becoming more complex every day.
Another reason for hedging the exposure of the firm to its financial price risk is to improve or
maintain the competitiveness of the firm. Companies do not exist in isolation. They compete
with other domestic companies in their sector and with companies located in other countries
that produce similar goods for sale in the global marketplace. Again, a pulp-and-paper company
based in Canada has competitors located across the country and in any other country with
significant pulp-and-paper industries, such as the Scandinavian countries.

6.1 Objectives of Hedging

Straightaway, we can see that there are a number of issues that present themselves.

First, what is the hedging objective of the firm?
Some of the best-articulated hedging programmes in the corporate world will choose the
reduction in the variability of corporate income as an appropriate target. This is consistent
with the notion that an investor purchases the stock of the company in order to take
advantage of their core business expertise.

Notes That a hedge is a financial instrument whose sensitivity to a particular financial
price offsets the sensitivity of the firm’s core business to that price.
Other companies just believe that engaging in a forward outright transaction to hedge
each of their cross-border cash flows in foreign exchange is sufficient to deem themselves
hedged. Yet, they are exposing their companies to untold potential opportunity losses.
And this could impact their relative performance pejoratively.

Second, what is the firm’s exposure to financial price risk?
Financial institutions whose core business is the management and acceptance of financial
price risk have whole departments devoted to the independent measurement and
quantification of their exposures. It is no less critical for a company with billions of dollars
of internationally driven revenue to do so.

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