To successfully use hedges as part of a risk management program, management must properly understand and communicate the hedge(s) to the company’s CEO and board. Furthermore, forethought and careful planning must accompany the decision to hedge in the pursuit of enhanced shareholder value.
What’s Inside?
Because it is a form of insurance, hedging entails costs to the insured, which may outweigh the benefits of coverage, depending on the risk in question. Accordingly, a firm contemplating a hedge needs to understand the risk it is attempting to mitigate and assess whether a hedge is the best way to do so.
How Is This Research Useful to Practitioners?
For a company to use a hedge effectively to enhance shareholder value, it must understand best practices in risk management. The author presents a framework to determine whether hedging can be cost-effective. Criteria include knowing what risks to retain or transfer, the role of risk management relative to equity issuance, and the knock-on effects of a strategy on return generation. Underpinning all of these considerations is management’s effective communication of them to the firm’s CEO and board.
Knowing when to hedge means knowing why: To what nonproductive risks is the company exposed; what would it cost to transfer those risks to a party better suited to bear them? A hedge’s value lies in its ability to transfer risk—similar to how insurance coverage transfers risks from the insured to the insurance company—not to make or lose money. Would failure to hedge a risk result in losses and deadweight costs or longer-term negative effects on firm profitability and valuation? Company management needs to understand the potential benefit of a hedge for its shareholders before the hedge is used, which means properly gauging the firm’s risk.
Such practitioners of risk management as chief risk officers understand and practice much of what the author discusses but will find the analysis a succinct guide to the process. Policymakers and regulators who oversee complex financial institutions will find worthy lessons here as well.
How Did the Author Conduct This Research?
Citing an example from Michael Lewis’s book The Big Short, the author recounts Morgan Stanley’s botched hedge against subprime risk, which turned into a costly blunder through the misuse of credit default swaps. The incident is a cautionary tale of protection, which incorporated a bet gone awry, and highlights the consequences of flawed planning.
A case study of a fictitious company’s exposure to and management of foreign exchange risk serves as a didactic tool for much of the article. The scenario effectively illustrates the complex issue of hedging and how an understanding of the reasons for doing so is crucial to a cost-effective approach. The analysis includes a discussion of costs and basis risk — both nontrivial considerations once a firm decides to hedge. Some treatment is given to how accounting rules can interfere with an otherwise prudent economic decision on whether to hedge. Finally, risk appetite not only informs the decision to hedge but also may inform how best to hedge. Hedging often involves the use of derivatives but also may include conventional financial instruments or such prudent operating decisions (e.g., “real hedges”) as selecting a particular manufacturing or distribution facility to mitigate foreign exchange risk.
Abstractor’s Viewpoint
Far from a panacea, hedging can be counterproductive when done incorrectly. A company must understand what it is attempting to hedge and when it is prudent to transfer risk rather than retain it. Assessment of risk appetite is the most important decision that a firm or individual makes because from it flows the decision to hedge or not and the implementation process if the hedge is undertaken.