21.2Why Do Firms Hedge?

Shortly after Iraq’s invasion of Kuwait on August 2, 1990, the price of oil went up sub-

stantially. Within months of the invasion, jet fuel prices more than doubled, increasing

Continental Airlines’fuel bill by $81 million a month. On December 3, 1990, Continen-

tal Airlines filed for Chapter 11 bankruptcy, citing rising fuel costs as the primary cause.⁵

If it were the rising fuel costs that bankrupted Continental, then the bankruptcy

would have been avoided if Continental had hedged the risk associated with increased

oil prices by making forward purchases of jet fuel prior to the Iraqi invasion. In retro-

spect, Continental’s managers wished that they had hedged. However, the issue

addressed in this section is whether or not Continental should have hedged knowing

only what they knew prior to the Iraqi invasion.

ASimple Analogy

In our everyday life, individuals make choices that reduce risk. For example, when the

authors of this text travel from UCLAto the Los Angeles Airport, they can choose between

taking the San Diego Freeway or taking city streets. Most of the time they take the freeway

because it is generally faster. However, travel time on the freeway varies considerably at rush

hour, depending on traffic conditions. Traveling the freeway between 4:00 and 6:00 P.M.takes

anywhere between 30 minutes and an hour, with an expected time of 40 minutes. With

certainty, it takes 50 minutes to get to the airport on city streets.

Even though, on average, it takes longer to go by the city streets, they prefer this

more certain route during rush hour because the loss from getting a bad outcome on

the risky route (for example, missing their plane) far outweighs the gain of getting a

good outcome on this route (for example, having enough time to get a drink before the

flight leaves). Generally speaking, it is this type of asymmetry between gains and losses

that leads us to make choices that reduce risk.

As we will show, similar asymmetries between losses and gains lead corporations

to make choices that reduce their risks. This will be true even if the corporation is

owned by stockholders who are risk neutral and thus prefer to maximize expected

return. We describe the sources of these asymmetries below.

How Does Hedging Increase Expected Cash Flows?

The rest of this chapter will examine various ways that firms can increase their expected

cash flows by implementing risk management programs. The primary benefits of hedg-

ing are related to taxes and to other market frictions discussed in Parts IVand V. Specif-

ically, we will discuss the following benefits associated with hedging:

1.Hedging can decrease a firm’s expected tax payments.

2.Hedging can reduce the costs of financial distress.

3.Hedging allows firms to better plan for their future capital needs and reduce

their need to gain access to outside capital markets.

4.Hedging can be used to improve the design of management compensation

contracts and it allows firms to evaluate their top executives more accurately.

5.Hedging can improve the quality of the investment and operating decisions.

⁵The Wall Street Journal,Dec. 4, 1990.

Grinblatt1499Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1499Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

744Part VIRisk Management

The gain from hedging in items (1) through (3) arises because the loss in the cor-

poration’s value from receiving one dollar less in profit is greater than the gain in value

from one dollar more in profit. For example, the third motivation is based on the idea

that the cost of not having enough internal capital available to fund a corporation’s

investment needs is greater than the benefits of having more than enough capital. Exam-

ple 21.1 illustrates how this asymmetry between gains and losses motivates firms to

hedge. Note that this example, as well as other examples in this chapter (unless spec-

ified otherwise), assume risk neutrality and a risk-free rate of zero. We use these

assumptions not just for expositional simplicity, but to show that firms have incentives

to reduce risk even when investors have no aversion to risk.

Example 21.1:How Hedging Creates Value

United Shoes exports U.S.-made shoes to the United Kingdom.Because of this, the firm’s

value is greater when the U.S.dollar is less valuable relative to the British pound.Suppose

that it is equally likely that the British pound will be worth US$1.40, US$1.50, or US$1.60

next year.Under these scenarios, United Shoes is worth US$105 million, US$140 million,

and US$160 million, respectively.By purchasing British pounds in the forward market at the

current forward price of US$1.52 per British pound, the firm will realize for certain a value

of US$138 million next year.Should United Shoes enter into the forward contract if its

investors are risk neutral?

Answer:The US$138 million realized by hedging exceeds the US$135 million the firm

would realize, on average, by not hedging.In this case, the firm benefits by hedging.

In Example 21.1, United Shoes was willing to take an unfair bet, paying $1.52 for

British pounds that would be worth only $1.50, on average, to reduce uncertainty.

United Shoes was willing to take this bet because movements in exchange rates that

lower profits hurt the firm more than the firm is helped by equal-sized exchange rate

changes in the opposite direction help it; that is, exchange rate uncertainty decreases

United Shoes’expected value. Thus, the firm could improve its expected value by

reducing this uncertainty.

In general, whenever a firm is hurt more by a negative realization of an economic

variable (for example, an exchange rate change) than it is helped by a positive realiza-

tion, the firm can increase its value by hedging. The following sections describe various

situations where we might expect the costs of negative realizations to exceed the bene-

fits of positive realizations. Each situation provides a motivation for why firms hedge.

How Hedging Reduces Taxes

Taxes play a key role in most financial decisions, and hedging is no different. Tax gains

often accrue from hedging because of an asymmetry between the tax treatment of gains

and losses. AU.S. corporation that has earned $100 million will pay about $35 million

in federal income taxes. However, if that same corporation loses $100 million, the IRS

will rebate its share of the losses only up to the amount of taxes the firm paid in the

prior two years.⁶Hence, the firm often loses more value from a $100 million pretax

loss than it gains in value from a $100 million pretax gain. Example 21.2 illustrates

how firms can gain from hedging risks in situations of this kind.⁷

⁶Tax losses also can be carried forward, up to twenty years, but the present value of the future tax

savings is less than the value of receiving the tax rebate immediately.

⁷Smith and Stulz (1985) discuss how hedging can be used by a corporation to reduce its expected tax

liabilities.

Grinblatt1501Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1501Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

745

Example 21.2:Taxes and Hedging

Cogen Pharmaceuticals sells a large fraction of its arthritis drugs in France for which it

receives payments in Euros.Given that its costs are denominated in U.S.dollars, the firm’s

taxable earnings are subject to currency risk.Currency fluctuations are the firm’s only source

of risk, so the firm’s pretax hedged and unhedged positions in two equally likely exchange

rate scenarios can be described as follows:

Pretax Income for Two Equally Likely Scenarios (in $millions)

Weak DollarStrong DollarAverage

Unhedged	$100	$20	$40
Hedged	35	35	35

The firm will thus achieve higher average pretax profits if it chooses not to hedge.Assume,

however, that there is a 40 percent profits tax, but no tax deduction on losses.Show that

the expected after-tax profits will be higher if the firm chooses to hedge:

Answer:

After-Tax Income for Two Equally Likely Scenarios (in $millions)

Weak DollarStrong DollarAverage

Unhedged	$60	$20	$20
Hedged	21	21	21

Result 21.3

Because of asymmetric treatment of gains and losses, firms may reduce their expected taxliabilities by hedging.

Hedging to Avoid Financial Distress Costs

Chapters 16 and 17 examined why financial distress can be costly. Distress costs include

costs arising from conflicts between debt holders and equity holders and those arising

from the reluctance of many of the firm’s most important stakeholders (for example,

customers and suppliers) to do business with a firm having financial difficulties. By

hedging its risks, a firm can increase its value by reducing its probability of facing

financial distress in the future.

An Example Based on the StakeholderTheory of Financial Distress.Consider, for

example, Microtronics, a medium-sized U.S.-based manufacturer of scientific equip-

ment, which needs to borrow $100 million to refinance an existing loan. Its operating

value next year is assumed to depend on two factors: the health of the U.S. economy

and the dollar/yenexchange rate. Microtronics’value is highest when (1) the U.S. econ-

omy is strong, since the demand for scientific equipment will then be strong, and (2)

when the yen is strong relative to the dollar, which increases the dollar costs of Micro-

tronics’Japanese competitors.

Grinblatt1503Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1503Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

746Part VIRisk Management

EXHIBIT21.1Microtronics’Unhedged Value in FourScenarios*

Strong U.S. EconomyWeak U.S. Economy

Weak yen	$150 million	$95 million
Strong yen	200 million	125 million

*Assumes customer confidence is high.

To evaluate Microtronics’loan application, the lender’s analysts have calculated the

firm’s operating values under four scenarios. The analysts have assumed that the firm

is unhedged and that customers maintain their confidence in the firm. These operating

values are described in Exhibit 21.1.

If the U.S. economy is weak and the yen is weak, the firm’s value ($95 million)

will be less than its debt obligation ($100 million). The bank is particularly concerned

about the weak economy because the $95 million value of the firm in this scenario

assumes that customers maintain their confidence in the firm. As Chapter 17 noted,

consumers of scientific equipment are reluctant to purchase from a firm with financial

difficulties because of potential difficulties in obtaining spare parts and service. Thus,

if Microtronics is unable to meet its debt obligations, its value in this scenario will be

considerably less than the $95 million it would be worth if the firm were solvent. If

the firm loses its customer base because of its financial distress, the bank may find it

difficult to recover even a small fraction of what it is owed on the loan.

By hedging some of its currency risk (that is, by selling forward or futures con-

tracts on the yen), Microtronics is betting that the yen will weaken relative to the dol-

lar. Such a bet increases the firm’s value in scenarios in which the yen is weak rela-

tive to the dollar and the firm is at a competitive disadvantage relative to its Japanese

competitors. Hedging currency risk, in effect, transfers value from the scenarios where

the yen is strong to scenarios where the yen is weak. If Microtronics hedges in a way

that transfers $15 million from the strong-yen scenario to the weak-yen scenario, its

values in the four scenarios would be as shown in Exhibit 21.2.

If Microtronics is hedged in this way, the bank is assured of being paid back in all

four scenarios and the firm will not be exposed to the costs of bankruptcy. Hence, in

the weak-yen, weak-economy scenario, hedging has eliminated the discrepancy between

the actual value of the firm and the value of the firm when customer confidence is

maintained.

Exhibit 21.3, which plots the distribution of profits with and without hedging, illus-

trates the potential advantages of hedging. The firm illustrated in this exhibit has a debt

obligation of $20 million and will suffer financial distress costs if it cannot meet this

obligation. The probability of not meeting the obligation is seen as the areas, to the left

of $20 million, under the two curves. Since this illustration assumes that hedging is

EXHIBIT21.2Microtronics’Hedged Value in FourScenarios

Strong U.S. EconomyWeak U.S. Economy

Weak yen	$165 million	$110 million
Strong yen	185 million	110 million

Grinblatt1505Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1505Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

	Chapter 21Risk Management and Corporate Strategy	747
EXHIBIT21.3	Distribution of Profits with and without Hedging

Probability of
achieving
	Distribution of hedged cash flows
cash flows

Distribution of

unhedged cash flows

Cash Flows

$20	$40$50	$70	$100
million	millionmillion	million	million

costly, the mean of the unhedged distribution is greater than the mean of the hedged

distribution. However, since the unhedged distribution has a larger variance, the area

to the left of $20 million is greater than the corresponding area for the hedged distri-

bution. In other words, hedging reduces the probability of financial distress.

Hedging does not always reduce the probability of financial distress. If the cost of

hedging is sufficiently large, and if hedging reduces variance very little, then hedging

may actually increase the probability of financial distress. Instances where this would

occur are very unusual. However, if it is costly, then hedging may not be worthwhile

for firms with very low financial distress costs.

Result 21.4Firms that are subject to high financial distress costs have greater incentives to hedge.

Hedging to Increase the Tax Shield from Debt Capacity.The Microtronics exam-

ple suggests that hedging reduces the expected costs of financial distress for any given

debt level. As hedging opportunities improve, however, firms can choose more highly

leveraged capital structures and take advantage of the tax and other advantages of debt

financing (see Chapters 14 to 19). To understand why hedging allows a firm to take on

more debt financing, consider again our analogy about the choice between taking the

freeway or taking city streets to the airport. Taking the freeway requires travelers to

allow at least an hour to get to the airport to be certain of catching the flight. How-

ever, when the slower but more certain option of taking city streets is available, trav-

elers can leave 10 minutes later even though, on average, this route takes 10 minutes

longer. Similarly, a firm that hedges its risks will be able to take on more debt while

keeping its probability of financial distress within a reasonable level.

Grinblatt1507Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1507Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

748Part VIRisk Management

Hedging to Help Firms Plan for Their Capital Needs

Internal Financing, Underinvestment, and Overinvestment.Previous chapters

explained why corporations view internal sources of equity capital as cheaper than

external sources. Recall that the lower costs of internal funds arise for information rea-

sons as well as because of taxes and transaction costs. Empirical evidence suggests that

because of the difference between the costs of internal and external capital, investment

expenditures by firms correspond closely to their cash flows. Firms thus have a ten-

dency to overinvest or underinvest, depending on the availability of internally gener-

ated cash flows. The reliance on internally generated cash can be especially costly to

firms that need to plan their investments in advance but have highly variable cash flows.

To the extent that hedging reduces this variability in cash flows, it can increase the

value of the firm.⁸

Consistent with this view, Lewent and Kearney (1990) noted in their explanation

of Merck’s strategy of actively hedging foreign exchange risk that a key factor in decid-

ing whether to hedge is the “potential effect of cash flow volatility on our [Merck’s]

ability to execute our strategic plan—particularly, to make the investments in R&D that

furnish the basis for future growth.” It is surprising that a firm like Merck, which has

easy access to debt markets and can borrow at one of the lowest corporate borrowing

rates available, would express such concerns. However, if Merck expresses concerns

about funding its strategic plans, firms with weaker credit ratings must have even

greater concerns.

Suppose, for example, that Compaq is planning to invest $100 million in manu-

facturing equipment next year, and that it can finance the investment from internally

generated cash flows if the dollar remains weak relative to the Euro. However, if the

dollar strengthens, Compaq is likely to lose money on its European sales and will

thus have considerably less cash available for investment. The executives at Compaq

believe that outside investors will become overly pessimistic about the firm’s future

prospects if the firm shows a loss next year because of currency fluctuations. In this

case the firm may not be able to issue equity or borrow at attractive terms and might

be forced to pass up this positive net present value project because of the negative

NPVof its outside financing alternatives. By hedging its currency risk, Compaq

assures the availability of sufficient capital to fund this investment opportunity.

Result 21.5

Firms that find it costly to delay or alter their investment plans and that have limited accessto outside financial markets will benefit from hedging.

The Desirability of Partial Hedging.If either the investment requirements or

thecosts and benefits of obtaining external financing are determined by the risk factor

the firm wishes to hedge, a firm may not want to completely hedge the risk. For exam-

ple, an oil firm may want to increase its exploration budget when oil prices are high.

If the firm can raise capital on more favorable terms after having shown increased earn-

ings, it will want to maintain some exposure to the risks of oil price fluctuations, so

that its earnings look good when there is a need for outside capital. Such a firm would

not choose to completely eliminate its exposure to oil price movements, but it still

would like to hedge risks to guarantee sufficient investment funds in the event of sub-

stantial oil price declines.

⁸This is discussed in more detail in Lessard (1991) and Froot, Scharfstein, and Stein (1993).

Grinblatt1509Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1509Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

749

Example 21.3:National Petroleum’s Partial Hedge

National Petroleum currently has 3 million barrels of oil in reserves that will be extracted

within the next three years at the rate of 1 million barrels of oil per year.Extraction costs

are $6 per barrel and are expected to remain stable for the next three years.The current

price of oil is $22 per barrel.Given current conditions, National is no longer exploring for

new oil, but the company plans to reassess the situation after three years.If oil prices exceed

$30 per barrel, National will reestablish its exploration operations, which will require a capi-

tal investment of $35 million.

Forward contracts for the delivery of oil in one, two, and three years are available at a

price of $24 per barrel.National has overhead costs of about $3 million per year and inter-

est obligations of $8 million per year.The firm will suffer significant financial distress-related

costs if it cannot meet these fixed obligations should oil prices fall significantly.How much

should National hedge?

Answer:National would like to hedge its oil price risk in a way that guarantees it will

generate at least $11 million from its operations, so that it can cover its overhead costs

and interest obligations.National can accomplish this by selling its entire supply of oil on

the forward markets, which would guarantee cash flows of $18 million in each year.How-

ever, if the firm is completely hedged, it will not accumulate enough internally generated

capital to fund new exploration efforts if oil prices exceed $30 per barrel.For this reason,

National should hedge only enough to avoid financial distress, so that it has more money

available if oil prices rise.Using the forward markets to sell 17/24 of its extracted oil annu-

ally is one way to achieve this.

As Example 21.3 illustrates, the fact that oil companies have greater investment

needs when oil prices are higher provides one explanation for why these companies

generally hedge very little of their oil price risk. As we discuss in Chapter 22, this also

provides a motivation for the use of options to hedge oil price risk since they can be

used to guarantee sufficient profits to avoid financial distress while allowing the firm

to benefit from very high oil prices. The incentive of oil firms to hedge may also be

reduced by the fact that the forward price of oil has generally been less than, rather

than greater than, the spot price of oil, and as a result, there has historically been a

positive expected cost of hedging (see footnote 3 for further discussion).

How Hedging Improves Executive Compensation Contracts and Performance Evaluation

Chapter 18 discussed conflicts of interest between shareholders and management and

ways to design executive compensation contracts that minimize the costs of these con-

flicts. Recall that executive compensation should be designed to expose managers to

the risk associated with factors they control (for example, success at cutting costs) while

minimizing exposure to risks they do not control (for example, changes in interest

rates). This suggests that a well-designed compensation package will not leave a risk-

averse executive exposed to the risks of currency fluctuations, interest rate changes,

and other factors over which the executive has no control.

Consider, for example, an Irish electronics company which sells most of its prod-

ucts in the United States. Its costs are mainly in Irish pounds, but its revenues are pre-

dominately in U.S. dollars. If the dollar strengthens against the pound (that is, if the

company receives more pounds for every dollar it receives), then the company’s prof-

its increase since its revenues improve while its costs (in pounds) remain constant.

Obviously, shareholders benefit from this, but it makes no sense to reward the com-

pany’s top executives for this unexpected increase in profits because the exchange rate

Grinblatt1511Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1511Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

750Part VIRisk Management

change is completely outside of their control. It also makes no sense to penalize the

executives for a decline in profits owing to a weakening of the dollar. The shareholders

would like to eliminate risk that managers cannot control to the greatest extent possi-

ble so they can increase the managers’exposures to the risks they do control.

It is no doubt difficult to design a compensation package that eliminates a man-

ager’s exposure to all hedgeable risks. Doing this would create an excessively compli-

cated contract and require prior knowledge of exactly how interest rates, currency

movements, and other hedgeable risks affect earnings and firm values, and how these

relationships change over time. Corporations, however, may be better able to accom-

plish this objective with much simpler performance-based contracts if they allow their

managers to hedge the appropriate risks and compensate them in a way that gives them

the incentive to hedge.

An additional, but related, advantage of implementing a hedging program is that by

requiring its managers to hedge, a firm will be able to evaluate its executives more accu-

rately. Earnings become a more accurate indicator of managerial performance when

extraneous noise in the earnings (that is, outside the managers’control) is eliminated.

Unhedged risks provide managers with additional excuses when earnings are poor. A

common excuse might be that “the earnings would have been much better if the dollar

hadn’t weakened.” Unhedged risks might also mask poor performance when managers

are lucky enough to realize gains resulting from favorable currency or interest rate changes.

Evaluating the Management at International Chemicals

Despite being a relatively small chemical company, International Chemicals (IC) is a true

multinational. It has production facilities in France, the United States, and Malaysia and

sells its products throughout the world. Despite IC’s diversification, its earnings have been

extremely volatile, particularly so in 1992. Management explained the poor performance in

that year, especially in the firm’s European sales, as the result of the rapid decline in the

British pound, which fell by more than 20 percent relative to the U.S. dollar. Because of

the pound’s decline, International Chemicals was at a serious disadvantage relative to its

most important competitor, which is located in the United Kingdom.

The board of directors of International Chemicals found management’s explanation plau-

sible. However, board members wondered how much of the record performance in earlier

years could be attributed to favorable shifts in exchange rates rather than to the hard work

and clever decisions of the company’s top managers. Asenior director raised the following

concern: How can we evaluate our top managers with such volatile currencies? When they

do poorly, they can almost always point to losses owing to currencies moving against them.

When they do well, we will always suspect that they were lucky and that currencies moved

in a favorable direction.

In response to this concern, one of the directors made the following proposal: At the end

of each year, the next year’s earnings would be projected. The managers would receive a

bonus if the earnings projection were exceeded, but there would be an even greater penalty

for doing worse than the projection. The penalty for failure in meeting the projection would

provide management with an incentive to use the futures market to hedge currency risks,

so that unfavorable currency movements would not cause them to fall below their projec-

tions. The directors making the proposal believed that by motivating management to hedge

the effects of currency movements, it would be much easier to assess the quality of man-

agement’s performance.

One of the newer board members questioned the wisdom of this hedging policy.

Shouldn’t the board encourage managers to take positions in currencies that are expected

to appreciate? The response of the senior board member was quite forceful. “We are in the

chemical business, not the foreign exchange trading business. It is unlikely that our finan-

cial managers would have any better knowledge about currency movements than the bankers

and professional speculators they would be “betting against” when executing such trades.

Grinblatt1513Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1513Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

751

In the absence of special information, a commodity or currency position is at best a zero

net present value investment which should be avoided.”

The senior manager also provided an additional advantage of implementing the new cor-

porate hedging policy: Managers who are confident about their abilities will be attracted to

firms that can evaluate their performance more accurately. Because a firm that chooses not

to hedge its risks might be regarded as one that is less able to evaluate its managers, it may

tend to attract managers who are less confident about their abilities and who prefer some

noise in the evaluation process.⁹

Result 21.6

The gains from hedging are greater when it is more difficult to evaluate and monitormanagement.

Disney’s Motivation to Hedge

Executives at Disney believe that by reducing the volatility of their profits from individual

business units they are better able to evaluate the business unit managers and assess the

profitability of their different lines of business. The executives also believe that if the over-

all firm is hedged, analysts will find the firm’s profits more easy to interpret and predict,

so that the firm’s stock price will reflect the firm’s true value more accurately.

As part of their evaluation system, the top executives at Disney’s central headquarters

and the top managers of the individual units agree on a target for each unit’s operating

profits in the next evaluation period. Managers must then implement a strategy that mini-

mizes their chances of not meeting the target. As part of this strategy, the individual units

initiate transactions with Disney’s treasury group to hedge their exposures to currency fluc-

tuations and other sources of hedgeable risks. The treasury group in turn hedges their expo-

sures in the derivatives markets.¹⁰

How Hedging Improves Decision Making

The Disney discussion suggests that an active risk management program can improve

management’s decision-making process by reducing the profit volatility of individual

business units. Less volatile profits for a company’s business units provide manage-

ment at the firm’s central headquarters with better information about where to allocate

capital and which managers are the most deserving of promotions.

Using Futures Prices to Allocate Capital.Firms with sophisticated risk management

groups have further advantages derived from their greater understanding of market

prices, which they can utilize to make better capital allocation decisions. As Chapter11

discussed, futures prices, viewed as certainty equivalents, provide an assessment of the

current value of pork bellies delivered in one year, enabling a farmer to make intelli-

gent decisions about whether to increase hog production. If the farmer’s costs are less

than the futures price, he can increase his production and sell the futures contracts to

lock in his gains. If the costs exceed the futures price, then the farmer should proba-

bly cut his production.

Although we believe that futures markets generally lead managers to make better

decisions, managers sometimes ignore new price information after hedging and, as a

result, often make serious mistakes. This is what we call the fallacy of sunk costs, which

Example 21.4 illustrates:

⁹Theoretical articles by DeMarzo and Duffie (1995) and Breeden and Vishwanathan (1996) explore

how information issues affect hedging choices.

¹⁰The

material on Disney is based on the discussion by Ken Frier, vice president for financial risk

management, at the UCLARisk Management Conference, March 30, 1996.

Grinblatt1515Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1515Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

752Part VIRisk Management

Example 21.4:Hedging and Production Choices: APitfall

Omega Chemicals sells a lemon-scented detergent base that is used by producers of both

laundry detergent and dishwashing soap.Lemon oil is one of its most expensive ingredients

and its price is volatile.To hedge this price risk, Omega made a forward purchase of 300,000

pounds of lemon oil at $4.50 per pound for delivery over the next 12 months.Subsequent

to this purchase, the price of lemon oil increased to $6.25 per pound because of political

uncertainties in one of the major exporting countries.Omega’s management views this as a

prime opportunity to aggressively increase its market share given its “cost advantage”over

its leading competitor, whose management chose not to hedge and thus must pay $6.25 per

pound for the lemon oil.Do you agree with management’s logic?

Answer:Omega is much better off as a result of its forward purchase of lemon oil.How-

ever, the opportunity costs associated with the input of one pound of lemon oil is $6.25 rather

than $4.50.Although it will be purchasing the lemon oil for $4.50 per pound, Omega could,

if it wished, sell the lemon oil on the open market for $6.25.Hence, although the company

made more than $500,000 on the forward purchase, its costs of using lemon oil have effec-

tively increased just as much as those of its competitors.

When making pricing and other operating decisions, managers must rely on oppor-

tunity costs instead of historical costs. Managers who understand this should be able

to greatly improve their operating and investment decisions when futures and forward

markets exist for either their inputs or outputs.

Aluminum smelters located on the West Coast of the United States showed a good

understanding of this concept during the 2000–2001 electricity crisis when electricity

prices skyrocketed. Since electricity constitutes approximately 25 percent of the cost of

producing aluminum, smelters tend to partially hedge their electricity costs with forward

contracts. Because of these forward commitments the aluminum producers could have

operated profitably during the crisis. However, they understood that the opportunity cost

of the electricity was the spot price, not their contract prices, and shut down their

smelters when prices peaked and sold their electricity on the open market. During such

periods, the smelters could make more money selling electricity than selling aluminum.

The Los Angeles Department of Water and Power (DWP) did not exhibit similar

judgment in the same crisis. Despite the increase in wholesale electricity prices, the

DWPdid not raise prices for the residents of Los Angeles. This would have provided

an incentive for Los Angeles residents to conserve electricity, allowing the DWPto

sell the electricity to the rest of California, which was suffering from a serious short-

age. The claim was that there was no need to make Los Angelenos suffer the same

high prices as the rest of California given that the DWP, with its own production

facilities, and prior contracts, could have charged the citizens of Los Angeles less

and still made a profit. However, the higher prices could have been offset by reim-

bursements to Los Angeles’citizens in the form of lower taxes or could have gener-

ated additional revenue for Los Angeles’coffers, which would have been a comfort-

ing insurance policy against a future economic downturn. Instead, the low electricity

prices generated wasteful usage by Los Angeles’citizens.

Using Information from Insurance Premiums to Allocate Capital.One way to

value the uncertain negative cash flows associated with adverse events is to use insur-

ance premiums to obtain certainty equivalents. However, as the discussion below illus-

trates, there are risks that are best left uninsured.

Grinblatt1517Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1517Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

753

British Petroleum’s Insurance Choices

British Petroleum (BP), recognizing that hedging risks can result in better decision mak-

ing, revised its corporate insurance strategy in a somewhat unconventional way.¹¹The con-

ventional wisdom is that corporations should insure large risks but not small risks because

small risks should average out over time and can be diversified within the firm. British

Petroleum, however, decided to take the opposite approach: to insure its small risks but

not its large risks. The reason has absolutely nothing to do with the motivations for hedg-

ing described earlier. Instead, British Petroleum’s rationale relates to how hedging affects

decision making.

To understand BP’s rationale, consider the issues involved in deciding whether to

spend $50 million on new refining capacity. There are a number of uncertain but insur-

able expenses associated with such an operation. For example, fires or natural disasters

raise the potential for lawsuits and on-the-job injuries might generate workers’compen-

sation claims. If these uncertain costs were uninsured, the calculation of the net present

value of the oil refining project would require BP’s management to calculate the expected

value of those uncertain losses as well as the corresponding discount rates.

The top executives of British Petroleum believe that insurance companies may be better

able than BPmanagement to calculate the present values of these insurable losses. One rea-

son has to do with incentives. Conceivably, a situation might arise in which a manager may

want to approve a marginal project and thus might tend to understate the potential losses

from fires and natural disasters. The second reason has to do with expertise. Insurance com-

panies are probably in a better position to assess the expected losses from fires and other

risks they insure as part of their regular business.

For more unusual and larger risks, BPprobably has the better information. One might

expect that it would have better information about the chances of incurring hundreds of

millions of dollars in damages from an explosion in one of its oil tankers, caused by neg-

ligence. Because the oil giant can better assess these risks, it is difficult and expensive

to insure against them. Insurance companies are concerned with the adverse selection

problem (see Chapter 19), which in this context implies that firms have an incentive to

insure those risks that insurance companies underprice. Understanding these incentives,

insurance companies use extremely pessimistic assumptions in assessing risks when they

are at an informational disadvantage compared with the firm’s management. As a result,

insurance quotes for these large risks are often unattractive to the firm.

Example 21.5 provides another example where the motivation for purchasing insur-

ance relates to information rather than risk sharing.

Example 21.5:Hedging a Halftime Contest

At halftime at the January 2000 Nokia Sugar Bowl, Robert Moderhak, a 54-year-old retired

school administrator, threw a football through a 2-foot-square target 15 feet away and won

$500,000.As it turned out, Nokia, the sponsor of the contest, had hedged the risk associ-

ated with this contest by paying $50,000 to a Dallas company, SCA Promotions, which was

responsible for paying the $500,000.Why did Nokia, a multibillion-dollar company, choose to

hedge such a small risk?

Answer:This hedge probably had more to do with information than risk.In doing the

cost-benefit analysis of this halftime promotion, Nokia needed to gauge the probability of los-

ing $500,000.This is a type of risk that Nokia knows nothing about.However, SCA, which

stands for Sports Contest Association, is an expert at analyzing such risks and is thus in a

better position to determine the expected cost of such a promotion.

¹¹British Petroleum’s insurance strategy is discussed in detail in Doherty and Smith (1993).

Grinblatt1519Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1519Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

754Part VIRisk Management

The insights illustrated by the British Petroleum case study and Example 21.5 are

summarized in Result 21.7.

Result 21.7

Firms have an incentive to insure or hedge risks that insurance companies and markets canbetter assess. Doing this improves decision making. Firms will absorb internally those risksover which they have the comparative advantage in evaluating.

21.3	The Motivation to Hedge Affects What Is Hedged

The previous section noted that hedging can improve the values of firms for a number

of reasons. In designing their risk management strategies, firms should consider each

of the individual reasons for hedging. For example, firms would like to minimize taxes

as well as the costs of financial distress, and they also would like a risk management

system that improves the quality of their management. Unfortunately, it may be diffi-

cult to do all of these things simultaneously. Afirm’s taxable income is not the same

as the income that it reports to shareholders, so minimizing the volatility of its taxable

income will not always minimize the volatility of its reported income. More impor-

tantly, a hedge that minimizes the volatility of a firm’s earnings will not always effec-

tively insure against longer-term changes in the firm’s value, which is likely to be more

important if there is concern about financial distress in the future.

Consider, for example, a Hong Kong textile firm which we will call Canton Inter-

national. The firm manufactures a variety of shirts that it sells mainly in Europe. The

firm is partially owned by one of Hong Kong’s wealthiest families, the Chans, who

also own a construction business and other small manufacturing firms. The Chan fam-

ily fully delegates the management of Canton International to a group of executives

whom they have recently hired. The Chans have let it be known, however, that the new

managers will be replaced if they do not perform well within the next two years.

The Chan family can best assess their managers if they require them to completely

hedge the firm’s foreign exchange risk over the next two years. They would prefer to

avoid replacing the managers because of poor performance if the problems were due

entirely to unfavorable and unexpected movements in exchange rates. Likewise, they

would not want to retain a poor-quality management team that was lucky enough to

experience favorable movements in exchange rates. These objectives suggest that the

Chans should require their management team to minimize the volatility of the firm’s

earningsover the next two years.

Unfortunately, this objective may only partially solve a second concern of the Chan

family. Canton International is a highly levered firm with a $100 million note due at

the end of five years. To minimize the chances of default, which would greatly embar-

rass the family, the Chans would like to instruct management to enter into forward con-

tracts that minimize their chances of defaulting on this note. However, implementing a

hedge that minimizes the chances of default will probably require larger positions in

the forward and futures markets than would be required to minimize earnings uncer-

tainty over the next two years because the firm’s valuerepresents the discounted value

of all future cash flows, not just the cash flows accruing in the next two years.

Result 21.8

If a firm’s main motivation for hedging is to better assess the quality of management, thefirm will probably want to hedge its earnings or cash flows rather than its value. However,if the firm is hedging to avoid the costs of financial distress, it should implement a hedg-ing strategy that takes into account both the variance of its value and the variance of itscash flows.

Grinblatt1521Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1521Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

755