21.10Summary and Conclusions

While we believe, as a general guideline, that most firmsoil firm would not want to completely hedge away the vari-can benefit by hedging, the gains from hedging differability in profits because that would leave it short of fundsacross firms. Firms can gain from hedging that reduceswhen favorable investment opportunities exist.their probability of being financially distressed, especiallyIn addition, firms may choose not to hedge those risksin those industries where financial distress costs are theabout which they have private information or which theyhighest. There are also tax reasons for distressed firms topartially control. In this respect, firm are similar to individ-hedge, and gains that come from the fact that a firm’s re-uals buying auto insurance. The safest drivers choose to beported cash flows and profits are more informative whenunderinsured since they regard insurance as overpriced.the firm has hedged out extraneous risks.Recognizing this tendency, insurance companies raise the

This chapter also considered situations where firmsrates for drivers wanting full insurance. In most cases,should not hedge. When excellent investment opportuni-these considerations do not affect whether firms hedge inties tend to arise at times when existing assets (unhedged)derivatives markets because firms are unlikely to have im-are most profitable, they may be better off remaining un-portant private information about currency and commodityhedged or only partially hedged. For example, an oil firmprice movements. However, these considerations do affectis likely to find more high-NPVexploration projects whenwhether firms insure against firm-specific risk or choose li-oil prices and hence unhedged profits are the highest. Anability streams that leave them exposed to changes in their

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Strategy, Second Edition

770Part VIRisk Management

own credit ratings. For the same reason that the safest driv-ers often choose to be underinsured, managers who believethat their firms are less risky than their credit rating reflectswill choose to borrow short term in hopes that their creditrating will improve in the future. In other words, the safestfirms will be overexposed to the risks connected withchanges in their credit rating.

Our discussion of both foreign exchange and liabilityrisk management indicated that implementing a sound riskmanagement strategy requires a good understanding of therelations between interest rate changes, exchange ratechanges, and inflation. The appropriate interest rate hedg-ing strategy depends on the extent to which interest ratevolatility is due to changes in the rate of inflation. Similarly,the appropriate foreign exchange hedging strategy dependson the extent to which currency fluctuations are due todifferences between domestic and foreign inflation rates.

This chapter presented our view of how firms can userisk management tools to maximize firm value, whichmay differ from current practice. This difference is partlydue to the limited experience many managers have indealing with derivatives markets and risk managementproblems and partly due to potential incentive problems(see Chapter 18). For example, if managers get a largeshare of their compensation from stock options—to solveone kind of incentive problem—they may choose tospeculate rather than hedge, since option values increasewith risk.

Again, we must stress that risk management, like allcorporate finance decisions, cannot be viewed in isolation.Corporations must view their risk management choices aspart of an overall strategy that includes their choice of cap-ital structure and executive compensation as well as con-siderations of overall product market strategy.

Key Concepts

Result	21.1:	If hedging choices do not affect cash	management, the firm will probably want
		flows from real assets, then, in the	to hedge its earnings or cash flows rather
		absence of taxes and transaction costs,	than its value. However, if the firm is
		hedging decisions do not affect firm	hedging to avoid the costs of financial
		values.	distress, it should implement a hedging
Result	21.2:	Hedging is unlikely to improve a firm’s	strategy that takes into account both the
		value if it does no more than reduce the	variance of its value and the variance of
		variance of its future cash flows. To	its cash flows.
		improve a firm’s value, hedging also	Result 21.9:Corporations should organize their
		must increase expected cash flows.	hedging in a way that reflects why they
Result	21.3:	Because of asymmetric treatment of	are hedging. Most hedging motivations
		gains and losses, firms may reduce their	suggest that hedging should be carried
		expected tax liabilities by hedging.	out at the corporate level. However, the
			improvement in management incentives
Result	21.4:	Firms that are subject to high financial
			that can be realized with a risk
		distress costs have greater incentives to
			management program are best achieved
		hedge.
			when the individual divisions are
Result	21.5:	Firms that find it costly to delay or alter
			responsible for hedging.
		their investment plans and that have
			Result 21.10:Managers have private information only
		limited access to outside financial
			in exceptional cases. Given this, they
		markets will benefit from hedging.
			almost always should be hedging rather
Result	21.6:	The gains from hedging are greater when
			than speculating.
		it is more difficult to evaluate and
			Result 21.11:Afirm’s liability stream can be
		monitor management.
			decomposed into two components: one
Result	21.7:	Firms have an incentive to insure or
			that reflects default-free interest rates and
		hedge risks that insurance companies and
			one that reflects the firm’s credit rating.
		markets can better assess. Doing this
			When a firm borrows at a fixed rate, both
		improves decision making. Firms will
			components are fixed. When it rolls over
		absorb internally those risks over which
			short-term instruments, the liability
		they have the comparative advantage in
			streams fluctuate with both kinds of risks.
		evaluating.
			Derivative instruments allow firms to
Result	21.8:	If a firm’s main motivation for hedging
			separate these two sources of risk: to
		is to better assess the quality of

Grinblatt1553Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1553Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

771

create liability streams that are sensitiveto minimize the exposure of its liabilities

to interest rates but not their creditto interest rate changes.

ratings, as described in equation (21.4),Result 21.13:Exchange rate movements can be

and to create liability streams that aredecomposed into those caused by

sensitive to their credit ratings but notdifferences in the inflation rates in the

interest rates, as described in equationhome country and the foreign country,

(21.5).and those caused by changes in realResult 21.12:If changes in interest rates mainly reflectexchange rates. In most cases, the

changes in the rate of inflation and if aincentive is to hedge against real

firm’s unlevered cash flows (and itsexchange rate changes rather than the

EBIT) generally increase with the rate ofcomponent of exchange rate changes that

inflation, then the firm will want itsis driven by inflation differences between

liabilities to be exposed to interest ratethe two countries.

risk. If, however, interest rate changesResult 21.14:When exchange rate changes can be

are not primarily due to changes ingenerated by both real and nominal

inflation (that is, real interest rateschanges, it may be impossible for firms

change) and if the firm’s unlevered cashto effectively hedge their long-term

flows are largely affected by the level ofeconomic exposures.

real interest rates, then the firm will want

Key Terms

economic risk763		real exchange rate763
hedge739		risk management739
liability management	758	risk profile739
liability stream758		transaction risk761
nominal exchange rate	763	translation risk762

Exercises

21.1.	Small firms currently hedge less than large firms.	can XYZ more easily hedge against the risk that
	Why is this? Do you expect smaller firms to start hedging more in the future? Explain.	manufacturing costs, measured in U.S. dollars, will become significantly more expensive? Why?
21.2.21.3.21.4.21.5.	Why is it harder to hedge currency risks in countries with volatile inflation rates? Whistler Resorts is a Canadian ski resort just northof Vancouver, British Columbia. Discuss theresort’s exposure to exchange rate risk. It is now much easier to hedge risks than it was inthe past. How should this affect a firm’s optimal capital structure? Why? The XYZ corporation manufactures in both Turkeyand Japan for export to the United States. Japan hasa stable monetary policy and, as a result, its inflationis easy to predict. Monetary policy in Turkey ismuch less predictable. In which of the two countries	21.6.Purchasing power parity (PPP) implies that real exchange rates remain constant. If PPPholds, do firms need to hedge their long-term foreign exchange exposure? Explain. 21.7.Oil firms hedge only part of their exposure to oil price movements. Why might that be a good idea?21.8.Harwood Outboard manufactures outboard motors for relatively inexpensive motor boats. The firm is optimistic about its long-term outlook, but its bond rating is only BB. Describe how you would manage Harwood’s liability stream if you believed that within two years Harwood’s credit rating would improve to A.

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Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

772Part VIRisk Management

References and Additional Readings

Block, S. B., and T. J. Gallagher. “The Use of Interest

Rate Futures and Options by Corporate Financial

Managers.” Financial Management15 (1986),

pp. 73–78.

Bodnar Gordon M., and Gunther Gebhardt. “Derivatives

Usage in Risk Management by U.S. and German

Non-Financial Firms: AComparative Survey.”

Journal of International Financial Management and

Accounting10, no. 3 (1999), pp. 153–187.

Bodnar, Gordon M.; Gregory S. Hayt; and Richard C.

Marston. “Wharton 1998 Survey of Risk

Management by U.S. Non-Financial Firms.”

Financial Management27, no. 4 (Winter 1998),

pp.70–91.

Breeden, Douglas, and S. Vishwanathan. Why Do Firms

Hedge? An Asymmetric Information Model.Duke

University working paper, 1996.

Chowdhry, Bhagwan, and Jonathan Howe. “Corporate

Risk Management for Multinational Corporations:

Financial and Operational Hedging Policies.”

European Finance Review2 (1999), pp. 229–46.

DeMarzo, Peter, and Darrell Duffie. “Corporate

Incentives for Hedging and Hedge Accounting.”

Review of Financial Studies8 (1995), pp. 743–71.Doherty, Neal, and Clifford Smith. “Corporate Insurance

Strategy: The Case of British Petroleum.” Journal of

Applied Corporate Finance6, no. 3 (Fall 1993),

pp.4–15.

Dolde, Walter. Use and Effectiveness of Foreign

Exchange and Interest Rate Risk Management in

Large Firms. University of Connecticut working

paper, 1993.

Froot, Ken; David Scharfstein; and Jeremy Stein. “Risk

Management: Coordinating Corporate Investment

and Financing Policies.” Journal of Finance48

(1993), pp. 1629–58.

Geczy, Christopher; Bernadette Minton; and Catherine

Schrand. “Why Firms Use Currency Derivatives.”

Journal of Finance52 (September 1997).

Haushalter, David. “Financing Policy, Basic Risk, and

Corporate Hedging: Evidence from Oil and Gas

Producers.” Journal of Finance 55 (2000),

pp.107–152.

Lessard, Don. “Global Competition and Corporate

Finance in the 1990s.” Journal of Applied Corporate

Finance3 (1991), pp. 59–72.

Lewent, Judy C., and A. John Kearney. “Identifying,

Measuring, and Hedging Currency Risk at Merck.”

Continental Bank Journal of Applied Corporate

Finance2 (1990), pp. 19–28.

Nance, Deana R.; Clifford W. Smith; and Charles W.

Smithson. “On the Determinants of Corporate

Hedging.” Journal of Finance48 (1993), pp.267–84.Rawls, S. Waite, and Charles W. Smithson. “Strategic

Risk Management.” Continental Bank Journal of

Applied Corporate Finance2 (1990), pp. 6–18.Shapiro, Alan, and Sheridan Titman. “An Integrated

Approach to Corporate Risk Management.” Midland

Corporate Finance Journal3 (1985), pp. 41–56.Smith, Clifford W., and Rene Stulz. “The Determinants of

Firms’Hedging Policies.” Journal of Financial and

Quantitative Analysis20 (December 1985),

pp.391–405.

Titman, Sheridan. “Interest Rate Swaps and Corporate

Financing Choices.” Journal of Finance47 (1992),

pp. 1503–16.

Tufano, Peter. “Who Manages Risk? An Empirical

Examination of Risk Management Practices in the

Gold Mining Industry.” Journal of Finance51

(September 1996), pp. 1097–1137.

Wall, Larry D., and John Pringle. “Alternative

Explanations of Interest Rate Swaps: An Empirical

Analysis.” Financial Management18 (1989),

pp.59–73.

Grinblatt1557Titman: Financial	VI. Risk Management	22. The Practice of Hedging	© The McGraw1557Hill
Markets and Corporate			Companies, 2002
Strategy, Second Edition

CHAPTER
22
	The	Practice	of	Hedging

Learning Objectives

After reading this chapter, you should be able to:

1.Describe the factor beta, standard deviation, and value-at-risk methods of

estimating risk exposure.

2.Use forwards, futures, swaps, and options to generate hedges.

3.Apply the covered interest rate parity relation in foreign exchange markets to

develop currency hedges.

4.Understand why and how to tail a hedge with futures and forwards.

5.Use regression and factor models to determine hedge ratios.

6.Describe the relation between hedging with regression, minimum-variance

hedging, and mean-variance analysis.

In the early 1990s, Metallgesellschaft AG, one of Germany’s largest conglomerates,

possessed considerable refinery capacity through a 51-percent-owned subsidiary.

Promises to sell heating oil from its subsidiary’s refineries to its customers at

guaranteed prices over the subsequent 10 years exposed the company to

considerable oil price risk. To offset the risk arising from these promises,

management at Metallgesellschaft decided to purchase crude oil futures contracts on

the New York Mercantile Exchange. In September 1993, oil prices dropped

precipitously and Metallgesellschaft began to receive margin calls on its futures

contracts. The cash required to meet these margin calls soon exceeded the company’s

revenues from its sales of heating oil and Metallgesellschaft was forced to liquidate

much of its futures position, resulting in $1.34 billion in capital losses. As a

consequence of this hedging fiasco, senior management was replaced, and academics

began to study what went wrong. The consensus was that Metallgesellschaft had the

wrong hedge ratio—so wrong that its futures position increased rather than

decreased the firm’s exposure to oil price risk.

The risks a firm faces in its operations, often called its exposures, include, for exam-

ple, exposures to interest rate risk, currency risk, business cycle risk, inflation risk,

773

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Markets and Corporate			Companies, 2002
Strategy, Second Edition

774Part VIRisk Management

commodity price risk, and industry risk. This chapter develops an understanding of how

to reduce these risk exposures.

Risk exposures are closely tied to the factor betas in factor models. Most of the

analysis of factor models in Chapter 6 focused on equity returns. In this context, value

hedging, the acquisition of financial instruments that alter the factor betas of the firm’s

equity return in order to reduce the firm’s equity return risks, is particularly pertinent.

However, as Chapter 21 noted, some firms focus on the risk of their near-term cash

flows rather than on the risk of their equity return. Reducing cash flow risk exposure

requires cash flow hedging,¹which is the acquisition of financial instruments to reduce

the cash flow factor betasof the firm (see Chapter 11). To minimize risk exposure, one

acquires financial instruments that, when packaged with the firm’s assets, results in fac-

tor betas that are close to zero. Alternatively, targeting a risk exposure involves setting

the factor beta to a target betalevel.

Numerous financial instruments are used for hedging. These instruments include for-

ward contracts, futures contracts, options, swaps, and bonds. The size of the position per

unit of the underlying asset or commodity that achieves minimum risk is known as the

hedge ratio.²

This ratio is often difficult to estimate. The proper instrument for hedg-

ing also may require complex analysis. In the Metallgesellschaft discussion in the chap-

ter’s opening vignette, for example, futures were ineffective instruments for hedging

exposure to oil price risk. Metallgesellschaft’s price guarantees to its customers, which

generated its oil price risk exposure, were long-term contracts. Metallgesellschaft, how-

ever, hedged this long-term exposure by rolling over a series of short-term futures con-

tracts. As this chapter later shows, it is not possible to perfectly hedge long-term oil

price commitments by rolling over a series of short-term futures contracts. In principle,

however, Metallgesellschaft could have better hedged its price commitments with more

complex derivative securities or with a more sophisticated hedging strategy.

Although this chapter touches briefly on the topic of interest rate risk, it leaves the

detailed analysis of interest rate risk to the next chapter. For the most part, we will use

commodity risk—risk exposure due to changing commodity prices—and currency

risk—risk exposure due to changing exchange rates—as illustrative cases to address

the basics of hedging.

Thefirstpartofthechapterdiscussesthemeasurementofriskexposure.Thesec-

ondpartassumesthatthefirmhasmeasureditsriskexposureproperlyanddesires

merelytofindtheproperhedgeratiotominimizeitsexposure.