This article will give a brief overview of the different ways in which firms approach this financial price risk and it will introduce the rationale for using derivative products. While there has been a great deal of negative attention paid to derivatives in the mainstream press, the opportunities they provide make derivatives a necessary part of the future of any corporation. Future articles in this series will identify the benefits and drawbacks of individual derivatives structures and explain some of the breakdowns in the application of derivatives by corporate end-users.
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. For 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.
Companies that are the most sophisticated in this field recognize that the financial risks that are produced by their businesses present a powerful opportunity to add to their bottom line while prudently positioning the firm so that it is not pejoratively affected by movements in these prices. This level of sophistication depends on the firm's experience, personnel and management approach. It will also depend on their competitors. If there are five companies in a particular sector and three of them engage in a comprehensive financial risk management program, then that places substantial pressure on the more passive companies to become more advanced in risk management or face the possibility of being priced out of some important markets. Firms that have good risk management programs can use this stability to reduce their cost of funding or to lower their prices in markets that are deemed to be strategic and essential to the future progress of their companies.
Most importantly, hedging is contingent on the preferences of the firm's shareholders. There are companies whose shareholders refuse to take anything that appears to be financial price risk while there are other companies whose shareholders have a more worldly view of such things. It is easy to imagine two companies operating in the same sector with the same exposure to fluctuations in financial prices that conduct completely different policy, purely by virtue of the differences in their shareholders' attitude towards risk.
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. For 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.
Companies that are the most sophisticated in this field recognize that the financial risks that are produced by their businesses present a powerful opportunity to add to their bottom line while prudently positioning the firm so that it is not pejoratively affected by movements in these prices. This level of sophistication depends on the firm's experience, personnel and management approach. It will also depend on their competitors. If there are five companies in a particular sector and three of them engage in a comprehensive financial risk management program, then that places substantial pressure on the more passive companies to become more advanced in risk management or face the possibility of being priced out of some important markets. Firms that have good risk management programs can use this stability to reduce their cost of funding or to lower their prices in markets that are deemed to be strategic and essential to the future progress of their companies.
Most importantly, hedging is contingent on the preferences of the firm's shareholders. There are companies whose shareholders refuse to take anything that appears to be financial price risk while there are other companies whose shareholders have a more worldly view of such things. It is easy to imagine two companies operating in the same sector with the same exposure to fluctuations in financial prices that conduct completely different policy, purely by virtue of the differences in their shareholders' attitude towards risk.
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