21.4How Should Companies Organize TheirHedging Activities?

In addition to understanding whether to hedge and how to hedge, firms must con-

sider the organization of their risk management activities. Should risk management

be centralized, operating out of the firm’s treasury department, or should hedging be

performed at the level of the individual divisions? The answer to this question

depends on the level of expertise in the various divisions, the availability of infor-

mation about the divisions’exposures, the transaction costs of hedging, and the moti-

vation for hedging.

At present, most risk management programs are implemented at the corporate rather

than the divisional level. One reason for this has to do with the costs of trading. In

illiquid markets, trading costs can be high, and it might make sense to consolidate trad-

ing. Consolidating allows the exposures of each of the business units to be netted

against one another. Corporate managers then execute trades in the financial markets

to hedge only the firm’s aggregate exposure. Asecond reason has to do with the rela-

tive newness of the field of risk management and the likelihood of limited expertise in

it at the divisional level. Afinal reason is the fixed costs associated with setting up a

risk management department.

As risk management expertise becomes more widespread and the futures, forward,

and swap markets become more liquid, we expect to see hedging performed more at the

divisional level. This is especially true when the principal motivation for hedging has to

do with improving management incentives. Division heads, who have the best informa-

tion about risk exposures in their divisions, ultimately should be responsible for hedg-

ing those risk exposures. Divisions also may want to hedge to assure themselves of

investment funds if investment funds from corporate headquarters are tied in some way

to the divisional profits. If, however, a firm’s principal motivation for hedging has to do

with either lowering expected tax liabilities or reducing the probability of bankruptcy,

then most hedging should be carried out at the corporate level.

Result 21.9

Corporations should organize their hedging in a way that reflects why they are hedging. Mosthedging motivations suggest that hedging should be carried out at the corporate level. How-ever, the improvement in management incentives that can be realized with a risk manage-ment program are best achieved when the individual divisions are responsible for hedging.

21.5	Do Risk Management Departments Always Hedge?

Until now, our analysis has assumed that the purpose of a risk management depart-

ment is to reduce the risks of a firm’s cash flows. However, some corporations view

risk management departments as “profit centers” and have encouraged them to

generate profits by speculating rather than hedging. Indeed, a number of firms have

generated large profits by speculating in currencies and interest rates. We think that

in most cases, these efforts are seriously misguided. There have been a number of

highly publicized cases where managers, thinking that they had special information,

bet heavily in futures markets—and lost. For example, in 1994 Procter and Gamble

gambledthat U.S. and German interest rates would fall and lost $157 million on two

interest rate swap contracts.¹²

¹²The

Wall Street Journal,Apr. 14, 1994.

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Certainly, cases do arise where firms have special information that leads them to

speculate instead of hedge. For example, Nestlé is one of the biggest buyers of cocoa

in the world and, as a result, it may have special information that allows the company

to better predict cocoa prices. Although Nestlé will want to buy cocoa futures to hedge

its anticipated future purchases, occasionally it will want to use its special information

to speculate. Suppose, for example, that Nestlé anticipates that its needs will be less

than normal over the next six months, resulting in a decline in cocoa prices. In this

case, Nestlé might choose to sell rather than buy cocoa futures.

The above example is somewhat atypical because only in exceptional cases do man-

agers have superior information about future price changes. For example, we are very

skeptical of corporate treasurers who claim to have superior information about foreign

exchange and use that information to speculate in those markets.

Result 21.10

Managers have private information only in exceptional cases. Given this, they almost alwaysshould be hedging rather than speculating.

21.6	How Hedging Affects the Firm’s Stakeholders

Up to this point, we have examined hedging from the perspective of managers who are

trying to maximize total firm value (that is, the value of the debt plus the value of the

equity). As Chapters 16 and 18 discussed, however, managers have competing pres-

sures and may not choose to maximize total firm value. Perhaps the instances where

firms were observed to be speculating rather than hedging arose because management’s

objective was notto maximize total firm value. In this section, we explore the effect

of hedging on the debt holders and equity holders separately, and how hedging can

affect other stakeholders of the firm.

How Hedging Affects Debt Holders and Equity Holders

Previous chapters described how equity can be viewed as a call option on the firm’s

value. To the extent that hedging reduces volatility without increasing firm value, it

reduces the value of this option, transferring value from equity holders to debt hold-

ers. From an equity holder’s perspective, the value-maximizing benefits of hedging

may be reduced, and possibly even reversed, by this transfer. The actions of man-

agers to hedge in these circumstances certainly would not endear them to these

equity holders. However, a firm’s bankers and bondholders would certainly like the

firm to hedge.

How Hedging Affects Employees and Customers

The interests of most of a firm’s employees are closer to the interests of debt holders

than to equity holders. Their jobs and reputations are at risk in the event of bankruptcy,

and they may not realize substantial benefits if the firm does extremely well. Managers

who look out for the interest of their employees would then have an incentive to hedge.

Customers generally like to see a firm that will honor its warranties, supply replace-

ment parts, and generate additional products that will enhance the value of existing

products. Since firms in financial distress are less likely to make choices that benefit

their customers, hedging also benefits a firm’s customers.

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Hedging and Managerial Incentives

The discussion in the previous subsection suggests that managers who are loyal to their

employees and customers may want to hedge more than the firm’s shareholders would

like them to. Managers’incentives to hedge differ from those of shareholders for sev-

eral other reasons.

Managerial Incentives to Hedge.Consider the case of an entrepreneur, like Bill

Gates at Microsoft, who starts a successful business and continues to hold a sizable

fraction of the firm’s shares. Gates is probably more concerned about Microsoft’s risk

than other shareholders because he is much less diversified than they are. As a result,

Gates might want Microsoft to hedge to reduce his personal risks even when doing so

has no effect on the firm’s expected cash flows. In this case, and in the absence of

transaction costs, Gates is indifferent between hedging on his personal account and

hedging through the corporation. However, it might be more efficient to have Microsoft,

which has a trained staff of risk management experts, bear the transaction costs rather

than bear these costs personally.

Managerial Incentives to Speculate.Managers also may have an incentive to spec-

ulate even when the firm would be better off hedging. As noted in the previous section,

this sometimes happens when managers have misguided notions that they possess supe-

rior information about future trends in currency and commodity prices. In addition,

managers may have an incentive to speculate if they are compensated with executive

stock options, which are worth more when stock price volatility is higher. Longer-term

considerations may provide managers with even more incentives to take speculative risks

and choose not to hedge. Managers who realize a favorable outcome as a result of a

risky strategy are likely to receive an attractive bonus and, in addition, be promoted and

have many more opportunities in the future. As long as their upside potential exceeds

their downside risk, managers will want to speculate rather than hedge.

The case of Nick Leeson and the bankruptcy of Barings Bank illustrates how per-

verse management incentives, along with a lack of oversight, can lead to disaster. By

making a series of enormous speculative bets on Japanese stock index futures, Leeson

managed to lose US$1.4 billion for his firm, Barings Bank, which ultimately led to the

firm’s demise in 1994. If these trades had been successful and Barings had earned

instead of lost over a billion dollars, Leeson would have received a generous bonus

and enjoyed increased opportunities and prestige within the firm. The upside associ-

ated with this risky strategy was clearly quite high. Perhaps Leeson believed that all

he had to lose in the event of a bad outcome was his job. Unfortunately, Leeson lost

not only his job but was sentenced to six years in a Singapore jail.

Before concluding this section, we should stress that the Barings case, the Procter

and Gamble case discussed in the last section, as well as the Metallgesellschaft case,¹³

attracted a great deal of attention because of the huge losses created by the improper use

of derivatives. However, these cases should not be viewed as typical. Our understanding

is that most managers use derivative instruments to hedge rather than to speculate and,

as a result, add value to their corporations. Unfortunately, well-run corporations that use

risk management tools effectively to benefit their shareholders are not nearly as news-

worthy as their counterparts that take ill-advised positions which bankrupt their firms.

¹³Metallgesellschaft

is discussed in Chapter 22.

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21.7	The Motivation to Manage Interest Rate Risk

Until now, we have discussed the motivations for risk management in general terms,

without reference to the particular sources of risk. In reality, however, a firm’s moti-

vation to hedge interest rate risk, which is closely tied to the capital structure choice,

may be quite different from its incentive to hedge either commodity or foreign

exchange risk.

Our earlier discussion of capital structure (Chapters 14–19) covered the issues

surrounding the firm’s choice between debt and equity financing in great detail. How-

ever, the choice between debt and equity financing is only the first step that firms

must take when they determine the overall makeup of their liabilities. Because they

affect who owns and controls the firm, decisions relating to the level of equity financ-

ing (for example, whether to issue new shares or repurchase existing shares) are

important decisions and are typically made at the highest levels of the corporation,

generally the board of directors, suggesting that a treasurer’s staff is unlikely to face

these types of decisions on a day-to-day basis. However, the nature of a firm’s debt

is something that the treasurer’s staff faces on a continuing basis. This includes choos-

ing whether to borrow at fixed or floating rates, or whether to roll over short-term

commercial paper. In addition, they decide whether to borrow in the domestic cur-

rency, in a foreign currency, or perhaps with commodity-linked bonds. These deci-

sions all affect the firm’s liability stream, which is the stream of interest costs that

a firm will be paying in the future.

We can view all of the above asliability managementdecisions because they

affect the nature of the firm’s liabilities. However, they also can be viewed as risk man-

agement choices, because the decisions affect the firm’s exposure to various sources of

risk. In general, when a firm determines its exposure to interest rates, commodities, and

foreign exchange through its borrowing choices without using derivatives, we think of

these choices as liability managementchoices. When the firm alters these risk expo-

sures with the aid of derivatives, we refer to this as risk management.However, since

in many cases a firm might be close to being indifferent between, for example, (1) bor-

rowing in dollars and swapping the dollar debt for a yen obligation, and (2) simply

borrowing in yen, this distinction between liability management and risk management

becomes largely irrelevant.

Alternative Liability Streams

It is useful to think about the different liability streams that a U.S. firm can create when

it is restricted to borrowing only in U.S. dollars. We further simplify this analysis by

assuming that there are only two possible maturities for the debt: short term and long

term. One might want to think of short-term debt as debt due in one year and long-

term debt as debt due in five years.

Whether the firm is borrowing short term or long term, its cost of borrowing will

consist of the sum of a risk-free component, r,which we can think of as a Treasury

bond rate, and a default spread, d,which is determined by the firm’s credit rating. As

we will see below, the firm can create four separate liability streams, depending on

whether the firm borrows short term or long term and whether it chooses to hedge its

interest rate exposure.

If the firm chooses to roll over short-term debt, its liability stream can be described

by the following equation:

i rd	(21.2)
ststst

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where

i the firm’s short-term borrowing cost for period t,which consists of:

st

r the default-free short-term interest rate for period t plus

st

d the default spread for period t

st

Note that the tsubscripts indicate that short-term borrowing rates and the firm’s credit

rating change over time.

If the firm instead chooses to borrow long term at a fixed rate, then its liability

stream can be described as:

i rd	(21.3)
lll

where

r the long-term interest rate

l

d the default premium

l

Since these rates are fixed for the life of the loan, they do not have the tsubscript.

The third approach involves a floating-rate loan. Firms may be able to obtain the

floating-rate loans directly from their banks or they can obtain the loans by borrow-

ing long term and swapping a default-free fixed-rate obligation for a default-free

floating-rate obligation (see Chapter 7). In either case, the floating-rate liability can

be described by

i rd	(21.4)
ftstl

where

i firm’s period tborrowing rate on the long-term floating rate loan

ft

This liability stream subjects the firm to interest rate risk (that is, changes in r), but

st

not to risk relating to changes in its credit rating.

The final possibility is a liability stream, i, that hedges the risk of changing lev-

ht

els of the default-free interest rate, r, but which leaves the firm exposed to changes

st

in its credit rating or default spread.

i rd	(21.5)
htlst

Firms were unable to create the liability stream described by equation (21.5) before

the introduction of interest rate swaps and interest rate futures. Before the introduction

of these instruments, borrowing short term implied exposure to interest rate risk and

credit risk, while borrowing long term implied exposure to neither. Indeed, the princi-

pal advantage of these derivative instruments is that they allow firms to separate their

exposures to interest rate risk from changes in their credit ratings. In particular, the lia-

bility stream described in equation (21.5) can be created by borrowing short term and

swapping a floating-for-fixed-rate obligation. Details on how to implement such a trans-

action are found in Chapter 22.

Result	21.11	Afirm’s liability stream can be decomposed into two components: one that reflects default-
		free interest rates and one that reflects the firm’s credit rating. When a firm borrows at a
		fixed rate, both components are fixed. When it rolls over short-term instruments, the lia-
		bility streams fluctuate with both kinds of risks.
		Derivative instruments allow firms to separate these two sources of risk: to create lia-
		bility streams that are sensitive to interest rates but not their credit ratings, as described in
		equation (21.4), and to create liability streams that are sensitive to their credit ratings but
		not interest rates, as described in equation (21.5).

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760Part VIRisk Management

How Do Corporations Choose between Different Liability Streams?¹⁴

To understand how corporations decide between the various liability streams, consider

the two components of their borrowing costs separately. We will first think about how

firms should structure their liabilities in terms of their exposure to changing levels of

interest rates. Then we will consider how firms decide on their exposure to changes in

credit risk. To determine the optimal exposure of their liabilities to interest rate risk,

firms must first think about the interest rate exposure they face on the asset side of

their balance sheets. In other words, firms must ask whether their ability to make a

profit is tied in any way to the prevailing interest rates in the economy.

Matching the Interest Rate Risk of Assets and Liabilities.The opening vignette to

Chapter 17 provides a vivid illustration of the risks connected with ignoring interest rate

exposure on the asset side of a firm’s balance sheet. Recall that Massey-Ferguson, a

manufacturer of tractors, was highly leveraged and had a substantial amount of short-

term debt financing. When interest rates increased at the end of 1979, farmers found it

difficult to buy and finance new tractors, causing Massey-Ferguson’s sales and operat-

ing income to drop substantially. In other words, the asset side of Massey-Ferguson’s

balance sheet was extremely sensitive to changes in interest rates and, as a result, the

interest rate sensitivities of the company’s assets and liabilities were severely mis-

matched. An increase in interest rates, which made its short-term debt more expensive

to service, coincided with a drop in the firm’s unlevered cash flows, which compounded

the problem and resulted in the firm facing severe financial distress. As a consequence

of financial distress, Massey-Ferguson was forced to downsize, laying off thousands of

employees. Perhaps those jobs could have been saved if Massey-Ferguson had done a

better job of matching the interest rate exposure of its assets and debt.

Decomposing Interest Rates into Real and Inflation Components.When thinking

about a firm’s interest rate exposure, recall that interest rates are composed of a real

component and an expected inflation component, as Chapter 9 discussed. In many

cases, a firm’s cash flows are unaffected by changes in the real interest rate, but they

are affected by changes in the inflation rate. For example, a manufacturer of furniture

may see its nominal profits increase when the general price level in the economy

increases if the prices that it charges and its labor costs increase at the overall rate of

inflation. The furniture manufacturer might then prefer to have a floating-rate liability

structure because it does not want to run the risk of being locked into high long-term

interest rates when inflation is reduced.

The experience many firms faced in 1982 provides a valuable lesson about the risks

connected with locking in long-term interest rates when inflation is uncertain. In the

early 1980s, interest rates were very high and many firms were locked into fixed obli-

gations with rates in excess of 15 percent. The high rates did not seem excessive at the

time since inflation was running at well over 10 percent per year. Firms were count-

ing on paying back expensive loans with cheaper dollars in the future. However, poli-

cies to reduce inflation appeared to be successful by the middle of 1982, substantially

increasing the real cost of existing fixed-rate loans. Short-term rates dropped substan-

tially in 1982, so that firms with a substantial amount of floating rate debt did much

better than firms that were stuck with fixed-rate obligations.

¹⁴For

more detailed analysis of the issues in this section, see Titman (1992).

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Result	21.12	If changes in interest rates mainly reflect changes in the rate of inflation and if a firm’s
		unlevered cash flows (and its EBIT) generally increase with the rate of inflation, then the
		firm will want its liabilities to be exposed to interest rate risk. If, however, interest rate
		changes are not primarily due to changes in inflation (that is, real interest rates change) and
		if the firm’s unlevered cash flows are largely affected by the level of real interest rates, then
		the firm will want to minimize the exposure of its liabilities to interest rate changes.

Hedging Exposure to Credit Rate Changes.In addition to evaluating a firm’s inter-

est rate exposure, we must ask how exposed the firm is to changes in its own credit

rating. In general, a firm would like to limit its exposure to changes in its own credit

rating since lenders almost always require larger default spreads when firms can least

afford to pay the higher interest rates. Hence, firms tend to prefer financing alterna-

tives that keep their default spreads fixed, such as long-term fixed-rate loans or float-

ing-rate loans. However, two factors offset this preference.

The first factor arises when there is disagreement about the firm’s true financial

condition. For example, the lender might believe that the firm will face financial

difficulties in the future, but the borrower believes that its credit rating is likely to

improve in the future. In this case, the borrower may not want to lock in what it con-

siders an unfavorable default spread, preferring instead to borrow short term in hopes

that its credit rating will improve in the future. The second factor arises because of the

conflicts between debt holders and equity holders discussed in Chapter 16. Recall that

a lender who is concerned that the firm will take on excessively risky investments (that

is, the asset substitution problem) is not willing to provide long-term financing on

favorable terms. Both of these factors imply that the firm may borrow short term, tak-

ing on greater exposure to changes in its own credit rating than it would otherwise

want, because the costs associated with long-term debt are simply too high. In these

situations firms often roll over short-term debt and use interest rate swaps to insulate

the firm’s borrowing costs from the effect of changing interest rates, thereby creating

the liability stream described in equation (21.5). We discuss how to do this in more

detail in the next chapter.