In the first article of this two-part series on hedging, we discussed two best practices in hedging policy management. In this article – part two of the series – we ask a precursor question: should my firm be hedging? The answer to this question will vary by firm and will depend on the circumstances surrounding the decision to hedge. Answering this question first requires asking a few other questions:
Is hedging aligned with our firm’s long-term business strategy?The topmost priority of a firm is to create value in a way that is sustainable for the long term. The way that most firms create value in the long term is to execute on business strategy; therefore, the decision to hedge or not to hedge ought to be aligned with company strategy.
At what cost could we hedge?It is important to note that, in almost all cases, shareholders can hedge far more cheaply than management can. Therefore, hedging employed to smooth out earnings will unlikely translate into a more valuable firm. Hedging will make sense in the case of a firm that faces significant costs from one or more of the following sources:
- The costs of financial distress (e.g., bankruptcy) – If a firm’s exposure to a financial risk is so high that the probability of having to face bankruptcy is considered high, then the firm should hedge to manage the risks and costs of bankruptcy.
- The costs to undiversified owners (e.g., employee/owners or owners of closely-held firms) – Owners that have most of their wealth tied up in one firm (such as a family-owned firm) will benefit from a lower cost of capital if the firm hedges large exposures.
- The costs of taxes – Reducing the volatility of pre-tax reported income may help, on the margin, to reduce the amount of cash taxes a firm owes, given issues such as the limits on carry-forward losses.
If a firm’s costs of hedging (i.e., transaction costs and employee time) are lower than the cost of the firm’s exposure to the three factors listed above, a firm should strongly consider hedging.
Are we seeking to eliminate risk or to better understand and manage it?A risk management system is not put in place to mitigate all risks. The key objective is to understand the risks the firm is facing and to evaluate if there are risks worth hedging. Depending on the situation, good risk management may mean hedging or not hedging.
Hedging is not right for every firm. The rationale when making this decision should be closely evaluated, with periodic checking thereafter to ensure that hedging is meeting its originally stated goals. If this is done properly, hedging can be an effective supporting tool for long-term value creation.