The final part of this article will introduce briefly the notion of hedging objectives. Each of these will be discussed in articles to follow.
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 programs 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.
Second, what is the firm's exposure to financial price risk?
It is important to measure and to have on a daily basis some notion of the firm's potential liability from 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.
There are three types of risk for every particular financial price to which the firm is exposed.
Transactional risks reflect the pejorative impact of fluctuations in financial prices on the cash flows that come from purchases or sales. This is the kind of risk we described in our example of the pulp-and-paper company concerned about their US$10 million contract. Or, we could describe the funding problem of the company as a transactional risk. How do they borrow money? How do they hedge the value of a loan they have taken once it is on the books?
Translation risks describe the changes in the value of a foreign asset due to changes in financial prices, such as the foreign exchange rate.
Economic exposure refers to the impact of fluctuations in financial prices on the core business of the firm. If developing markets economies devalue sharply while retaining their high technology manufacturing infrastructure, what effect will this have on an Ottawa-based chip manufacturer that only has sales in Canada? If it means that these countries will flood the market with cheap chips in a desperate effort to obtain hard currency, it could mean that the domestic manufacturer is in serious jeopardy.
Third, what are the various hedging instruments available to the corporate Treasurer and how do they behave in different pricing environments?
When is it best to use which instrument is the question the corporate Treasurer must answer. The difference between a mediocre corporate Treasury and an excellent one is their ability to operate within the context of their shareholder-delineated limits and choose the optimal hedging structure for a particular exposure and economic environment. Not every structure will work well in every environment. The corporate Treasury should be able to tailor the exposure using derivatives so that it fits the preferences and the view of the senior management and the board of directors.
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 programs 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.
Second, what is the firm's exposure to financial price risk?
It is important to measure and to have on a daily basis some notion of the firm's potential liability from 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.
There are three types of risk for every particular financial price to which the firm is exposed.
Transactional risks reflect the pejorative impact of fluctuations in financial prices on the cash flows that come from purchases or sales. This is the kind of risk we described in our example of the pulp-and-paper company concerned about their US$10 million contract. Or, we could describe the funding problem of the company as a transactional risk. How do they borrow money? How do they hedge the value of a loan they have taken once it is on the books?
Translation risks describe the changes in the value of a foreign asset due to changes in financial prices, such as the foreign exchange rate.
Economic exposure refers to the impact of fluctuations in financial prices on the core business of the firm. If developing markets economies devalue sharply while retaining their high technology manufacturing infrastructure, what effect will this have on an Ottawa-based chip manufacturer that only has sales in Canada? If it means that these countries will flood the market with cheap chips in a desperate effort to obtain hard currency, it could mean that the domestic manufacturer is in serious jeopardy.
Third, what are the various hedging instruments available to the corporate Treasurer and how do they behave in different pricing environments?
When is it best to use which instrument is the question the corporate Treasurer must answer. The difference between a mediocre corporate Treasury and an excellent one is their ability to operate within the context of their shareholder-delineated limits and choose the optimal hedging structure for a particular exposure and economic environment. Not every structure will work well in every environment. The corporate Treasury should be able to tailor the exposure using derivatives so that it fits the preferences and the view of the senior management and the board of directors.
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