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.
Consider the example of the Canadian pulp-and-paper company from before, 75% of whose product is sold in US dollars to customers located all over the world. The US dollar here is called the price of determination because all sales of pulp-and-paper are denominated in US dollars.
They close a deal for US$10 million worth of product and they know that in one month's time they will receive payment into their US dollar accounts. However, they understand that from the inception of the contract which binds them to have receivables in US dollars in one month's time they are exposed to changes in the rate of exchange for the Canadian dollar against the US dollar.
Immediately, they are faced with a problem. As a Canadian company, they will have to repatriate those US dollars at some point because they have decided that foreign exchange risk is not something that they are prepared to carry as it is deemed it to be peripheral to their core business.
The problem has two dimensions: uncertainty and opportunity.
If they do not hedge the transaction in any way, they do not know with any certainty at what rate of exchange they can exchange the US$10 million when it is delivered. It could be at a better rate or at a worse rate than the rate prevailing currently for exchange of that amount in one month's time.
Let's call the prevailing spot rate, for argument's sake, 1.5300 and the prevailing one month forward outright rate at which they could hedge themselves 1.5310.
If they do enter into a forward contract in which they obligate themselves to buy Canadian dollars and sell US dollars for delivery on the same date as the delivery date on their pulp-and-paper contract, they have removed this uncertainty. They know without any question at what rate this exchange will be. It will be 1.5310.
But, they have now taken on infinite risk of opportunity loss. If the Canadian dollar weakens because of some unforeseen event and in one month's time the prevailing spot rate turns out to be 1.5600, then they have foregone 290,000 Canadian dollars. This is their opportunity loss.
Are there instruments that address both certainty and opportunity loss? Fortunately, there are. They are called derivatives or derivative products. Most financial institutions make markets in a panoply of risk management solutions involving derivative products. Some of them come as stand-alone solutions and others are presented as packages or combinations.
A derivative product is a financial instrument whose price depends indirectly on the behaviour of a financial price.
For example, the price of a foreign exchange option on the Canadian dollar in which our company had the right but not the obligation to buy Canadian dollars and sell US dollars at a pre-set strike price will vary on a day-to-day basis with the movement in the Canadian dollar/US dollar exchange rate. If the Canadian dollar gets stronger, the Canadian dollar call becomes more valuable. If the Canadian dollar gets weaker, the Canadian dollar becomes less valuable.
Instead of entering into a forward contract to buy Canadian dollars, the pulp-and-paper company could purchase a Canadian dollar call struck at 1.5310 for a premium from one of its financial institution counterparties. Doing so reduces their certainty about the rate at which they will repatriate the US dollars but it limits their worst case in exchange for allowing them to enjoy potential opportunity gains, again conditioned by the premium they have paid.
Derivatives just like any other economic mechanism are best thought of in terms of tradeoffs. The tradeoffs here are between uncertainty and opportunity loss.
However, a Canadian dollar call is only one of the possible risk management solutions to this problem. There are dozens of possible instruments, each of which has a differing tradeoff between uncertainty and opportunity loss, that the pulp-and-paper company could use to manage this exposure to changes in the exchange rate.
The key to hedging is to decide which of these solutions to choose. Hedging is not just about putting on a forward contract. Hedging is about making the best possible decision, integrating the firm's level of sophistication, systems and the preferences of their shareholders.
Future articles will discuss in depth the nature of some of these alternative solutions and the ways in which firms approach these other instruments.
Consider the example of the Canadian pulp-and-paper company from before, 75% of whose product is sold in US dollars to customers located all over the world. The US dollar here is called the price of determination because all sales of pulp-and-paper are denominated in US dollars.
They close a deal for US$10 million worth of product and they know that in one month's time they will receive payment into their US dollar accounts. However, they understand that from the inception of the contract which binds them to have receivables in US dollars in one month's time they are exposed to changes in the rate of exchange for the Canadian dollar against the US dollar.
Immediately, they are faced with a problem. As a Canadian company, they will have to repatriate those US dollars at some point because they have decided that foreign exchange risk is not something that they are prepared to carry as it is deemed it to be peripheral to their core business.
The problem has two dimensions: uncertainty and opportunity.
If they do not hedge the transaction in any way, they do not know with any certainty at what rate of exchange they can exchange the US$10 million when it is delivered. It could be at a better rate or at a worse rate than the rate prevailing currently for exchange of that amount in one month's time.
Let's call the prevailing spot rate, for argument's sake, 1.5300 and the prevailing one month forward outright rate at which they could hedge themselves 1.5310.
If they do enter into a forward contract in which they obligate themselves to buy Canadian dollars and sell US dollars for delivery on the same date as the delivery date on their pulp-and-paper contract, they have removed this uncertainty. They know without any question at what rate this exchange will be. It will be 1.5310.
But, they have now taken on infinite risk of opportunity loss. If the Canadian dollar weakens because of some unforeseen event and in one month's time the prevailing spot rate turns out to be 1.5600, then they have foregone 290,000 Canadian dollars. This is their opportunity loss.
Are there instruments that address both certainty and opportunity loss? Fortunately, there are. They are called derivatives or derivative products. Most financial institutions make markets in a panoply of risk management solutions involving derivative products. Some of them come as stand-alone solutions and others are presented as packages or combinations.
A derivative product is a financial instrument whose price depends indirectly on the behaviour of a financial price.
For example, the price of a foreign exchange option on the Canadian dollar in which our company had the right but not the obligation to buy Canadian dollars and sell US dollars at a pre-set strike price will vary on a day-to-day basis with the movement in the Canadian dollar/US dollar exchange rate. If the Canadian dollar gets stronger, the Canadian dollar call becomes more valuable. If the Canadian dollar gets weaker, the Canadian dollar becomes less valuable.
Instead of entering into a forward contract to buy Canadian dollars, the pulp-and-paper company could purchase a Canadian dollar call struck at 1.5310 for a premium from one of its financial institution counterparties. Doing so reduces their certainty about the rate at which they will repatriate the US dollars but it limits their worst case in exchange for allowing them to enjoy potential opportunity gains, again conditioned by the premium they have paid.
Derivatives just like any other economic mechanism are best thought of in terms of tradeoffs. The tradeoffs here are between uncertainty and opportunity loss.
However, a Canadian dollar call is only one of the possible risk management solutions to this problem. There are dozens of possible instruments, each of which has a differing tradeoff between uncertainty and opportunity loss, that the pulp-and-paper company could use to manage this exposure to changes in the exchange rate.
The key to hedging is to decide which of these solutions to choose. Hedging is not just about putting on a forward contract. Hedging is about making the best possible decision, integrating the firm's level of sophistication, systems and the preferences of their shareholders.
Future articles will discuss in depth the nature of some of these alternative solutions and the ways in which firms approach these other instruments.
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