Page 31 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 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.

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. As we shall see in this article and the ones that follow, 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.
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Caution Hedging Problem
The core problem when deciding upon a hedging policy is to strike a balance between
uncertainty and the risk of opportunity loss. It is in the establishment of balance that we
must consider the risk aversion, the preferences, of the shareholders. Make no mistake
about it. Setting hedging policy is a strategic decision, the success or failure of which can
make or break a firm.

3.1.1 Objectives of Hedging

Earlier, we noted 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. 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.
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.

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