- September 27, 2022
- Posted by: Ramkumar
- Category: Strategy
Managing Risk And When Corporate Hedging Work
As Fed continue to increase interest rates, it has triggered uncertainties in commodity prices, exchange rates and interest rate changes. The Indian rupee is at an all-time low of 81.52/USD, and other major currencies have weakened against the USD. The Fed’s actions have prompted firms to take multiple actions, from hedging to buying insurance contracts to protect themselves against falling asset prices. The Indian IT industry share prices have plunged to a 52-week low because most of its revenues depend on the US. At one level, we can shrug it as interest rate parity as US interest rates have risen faster than other countries; we cannot ignore the investor’s flight to safety to park their capital in a safer haven (seen by higher FII sell-off in the last few months). With the Indian rupee weakening against the USD, the firms will look at hedging to protect the currency exchange risks. One of the reasons this inflationary period is causing concern is the long period of low, stable inflation in the last decade. Thus, people and companies did not plan for a change in their business models or earnings patterns to deal with high inflation. In this post, I provide my insights on the risk management strategies firms take to avoid risks by using financial contracts like insurance, futures and swaps to protect against falling commodity prices, interest rate changes and exchange rate fluctuations. Further, my analysis shows that firms should not hedge all risks, only those they can exploit, or that the shareholders/investors cannot hedge. Further, i end this post by explaining why hedging is a zero-sum game and hedging strategies that reduce risk does not increase a firm’s value.
For instance, an oil company cannot increase their value by selling oil futures to protect its revenue volatility because shareholders can do it themselves. The reason why investors purchase oil shares is that they want to take a bet on oil prices. If an oil refinery firm enters into a forward contract with an oil distributor by locking in the future prices, they are protecting their revenues against future price changes. Investors can do the same by buying oil distributor stocks and oil refinery stocks. Thus, when an oil refinery firm hedges, it does not add any shareholder value.
If the firm has high debt, the changing interest rates due to inflation can make a firm distressed or even push it to bankruptcy. In such cases, firms should hedge to have stable cash flows to pay their interest payments and take advantage of any NPV-positive investment opportunities. The other alternative is to link the firm’s revenues to the interest rates by entering into a swaps agreement; in that case, if the firm’s revenues fall, the interest rates will decline accordingly, and the firm will have lower interest payments which will prevent default risk.
Before discussing the firm’s risk management strategies, I will give a brief overview of Futures, Options and Swaps that firms use to hedge risk.
Options – Managers buy options on currencies, interest rates and commodities to reduce downside risk. For instance, Mexico gets 30% of its revenues from Pemex – An state-owned oil company. So when oil prices decline, the government has to reduce its planned expenditure toward its citizen’s welfare. For example, if the oil price has fallen from $130 to $100 per barrel, the government can hedge its risk by buying put options at $120 as an exercise price. Thus, despite the oil price declining to $100, the firm can sell oil at $120 despite the oil price declining to $100 per barrel. Thus, the government has effectively hedged itself against any downside risk in oil prices. However, this hedging does not come free. The government has to purchase the option contracts. In many cases, the put option contracts come at high costs if the firms do not know to hedge appropriately. For instance, airline companies face huge losses when they sell Put options against oil prices to offset the cost of buying calls against oil prices designed to hedge against higher oil prices.
Forward and Futures Contracts – A forward contract is a commitment that parties arrive at to sell/buy a commodity at a fixed price at a future date. The payment and delivery will happen at a future date while the parties have fixed the price today. This price differs from the current price (also known as the spot price). The parties commit to buy/sell at a future date, which differs from an option where the option holder is not obligated to buy/sell. In the forward contracts, there is a counterparty risk as one of the parties can renege on the commitment; thus, to mitigate counterparty risks, the firm can trade these contracts in exchange. When forward contracts trade in exchange, they become futures contracts. Thus, when a farmer selling wheat produce sells wheat futures to offset any decline in wheat prices, a distributor that intends to buy wheat will buy wheat futures. Though farmers and distributors enter into futures to protect themselves against the volatility in wheat prices, the gain enjoyed by the farmer in the case of a decline in wheat prices gets offset by losses for distributors who could have bought the wheat at lower prices. Thus hedging is a zero-sum game as one party wins at the expense of another.
Another example of why hedging is a zero-sum game is when an oil refinery sells oil futures at $2 per gallon. If the oil price is at $2.10 per gallon, the refinery can sell oil at higher prices, but the futures contract losses offset this gain. Thus, the NPV of hedging is always zero, and the firms cannot add shareholder value by hedging.
Swaps – Swaps are instruments that help parties to exchange their risk profiles. For instance, if a bank funds a $50 million loan at an 8% fixed interest rate for five years, it will receive an annual interest payment of $4 million. The bank can convert this fixed interest payment to a floating rate by entering a swap agreement with a dealer. Assuming the bank borrows a loan at a 6% interest rate, it has a better credit rating than the borrower. As the bank already receives $4 million in interest annually, the maximum loan it can borrow is $4 million/6% = $66.67 million. The bank swaps this $66.67 million fixed-rate loan with a swap dealer for payments on an equivalent floating rate loan (linked to LIBOR rate). So when the interest rate rises to 7%, the swap dealer has to pay 7% interest to the bank while the bank will pay 6% fixed interest.
For a five-year swap, the NPV for the bank engaging in this swap transaction, assuming that the interest rate increases to 7%, is:
NPV = 66.67 – 4/1.07-4/(1.07^2)-4/(1.07^3) – 4/(1.07^4) – (66.67+4)/(1.07^5) = $2.73 million
Thus, by entering the interest rate swap agreement, the bank gains $2.73 million if the interest rate increases to 7%. However, if the interest rate declines to 5%, the bank has to pay $2.89 million to the dealer.
When to Hedge
As I gave an overview of derivatives contracts, firms have many options to protect any downside risk from interest rates to inflation to commodity prices using derivatives/insurance.
However, in my view, in the current scenario, the firm should separate risks into three buckets:
- Do not hedge when investors can take care of it – Oil companies that face the risk of lower prices should not hedge by selling oil futures because investors buy oil companies’ shares to make a bet on oil prices. In my experience, firms that have given shares to managers usually hedge so that the share prices do not fluctuate. However, managers having options will not hedge because the value of options increases when there is higher volatility and risk.
- Hedge if you can avoid risks – Here, shareholders/investors cannot hedge because they are complex or not visible. Thus, companies must hedge; if it does not, it will affect their operations, even forcing them into bankruptcy. For instance, airline companies must hedge against rising fuel prices by buying oil futures to lock in fuel prices. If the airline companies hedge rightly, it can reduce operating costs and thereby reduce operating efficiency. However, the firm should not rely on a financial hedge; wherever possible, the firm should increase the prices when the input cost increases so that the price increase act as a natural hedge. This natural hedge, in combination with a financial hedge, helps firms sustain their operating margins. Similarly, companies investing in plants and property must take insurance to protect against any risks arising from property destruction or equipment damage. Thus, in the case of any casualty, the firm can salvage itself.
- The risk that the firm must exploit – Firms with competitive advantages like brands, patents and technologies must exploit risks by increasing prices to end customers. For instance, coke can increase its prices despite high inflation because customers will purchase coke due to its brand. Similarly, pharma companies can increase the prices of drugs because they have their IPs protected. Firms that have pricing power perform better during high inflationary periods.
Hedging strategies that reduce risk cannot add value because hedging is a zero-sum game. When hedging, we are not eliminating risk but transferring risks to other parties.
The concept of hedging is simple. You find two closely related assets. You then buy one and sell the other in proportions that minimize the risk of your net position. You can make the net position risk-free when there is a perfect correlation between the assets. Investors must absorb a Basis risk if they are less than perfectly correlated.
There are risks that companies need not hedge because investors can take care of by themselves, and there are risks that companies must hedge. However, entering into derivatives contracts by not holding the asset leads to speculation and firms engaging in speculation face higher bankruptcy risks.