May 31, 2011
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These days, given the complex web of global financial transactions in which companies are enmeshed, it is unrealistic to expect management to avoid hedging. When I invest, however, I search for companies that follow simple, consistent, and short-term hedging policies – and whose business models are strong enough to adapt to the inherent volatility and uncertainty of the marketplace.
Let’s look at the dangers posed by inappropriate hedging and how adept managers deal with volatile prices in an inflationary environment.
Good in theory, bad in practice
My library contains a classic textbook on corporate finance, and its chapter on the practice of hedging risk concludes as follows:
As a [company] manager, you are paid to take risks, but you are not paid to take any risks. Some are simply bad bets and others could jeopardize the success of the firm. In these cases you should look for ways to hedge.1
As the text suggests, theory tends to favor hedging techniques, although there is disagreement over what constitutes best practice. Among the potential benefits research papers cite are mitigating catastrophic risk, reducing financing costs, and smoothing fluctuations in cash flow, the last of which results in a discernible and positive impact on share prices.2 With benefits such as these, why wouldn’t all companies hedge?
Present inflationary conditions might further favor hedging. Imagine you are a manager in Brazil, where loose monetary policies at home and abroad are feeding inflationary pressures. You face persistent price increases on inputs essential to your company’s manufacturing process. Lost competitiveness and lower profits loom. The temptation to hedge such risks is overwhelming. After all, it’s not your fault that commodity prices are rising; why not have an investment bank create a customized derivative for you that locks in prices for 18 months? Why not smooth out the potential shock to your profits? Prices are moving in only one direction – why not even profit from the trend?
This may seem reasonable enough, in theory. The problem is that in my experience, it doesn’t work. I have seen hedging programs bring on several large-scale implosions. To name two: Citic Pacific, a well-connected Chinese conglomerate, lost billions in a foreign exchange contract gone awry; numerous small companies in Korea were knocked flat by their aptly-named “knock-in / knock out” currency derivatives.
Admittedly, those two cases are atypical, as they are examples of hedging gone very wrong. They illustrate a common characteristic, however: managers wished to insulate their firms from small price fluctuations, but they also wished to be clever, so they simultaneously bet against extreme and seemingly unlikely price movements. Basically, they eliminated one kind of risk, but they amplified another in exchange, and these new risks were harder to evaluate and potentially damaging. Their counterparties in these transactions were savvy banks, better-equipped to evaluate the underlying probabilities.
Guess who won the bet?
Keep it simple
Companies can hedge prices in myriad ways, but three techniques are most common:
- A company can hedge interest rate risk by buying contracts, swaps or related derivatives
- A company can hedge currency risks by borrowing (or lending) in a foreign currency, by purchasing (or selling) foreign currency, or by purchasing forwards, swaps or other derivative contracts that mimic such exposure
- A company can hedge input prices by purchasing commodity futures or forwards, or by stockpiling large quantities of raw materials, such as non-perishable commodities
1. Brealy and Myers, Principles of Corporate Finance, 4th Edition, 1991, page 644.
2. Lin, Pantzalis and Park, “Corporate Hedging Policy and Equity Mispricing,” 2005, page 4.
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