Hedging Operational and Financial Risks

The operational risks of a firm can be hedged by manging the production and sales activities of the firms. It involves managing expenses and revenue of the firm. Since expenses and revenues are part of the income statment, operational risk is also considered as income statement risk. Financial risk, on the other hand, involves balance sheet items, i.e., assets and liabilities. Given that financial markets are not perfect, hedging financial risk can provide substantial benefits. Effective hedging should address both a firm’s assets and liabilities to comprehensively manage these risks. The below section covers details related to heding pricing risk, foreign currency riska and interest rate risk.

Pricing Risk

A firm’s business can be significantly impacted by the fluctuations in the costs of inputs. Therefore, it becomes important to hedge this pricing risk by purchasing forward or futures contracts, allowing the firm to secure a specific quantity of the input at a predetermined fixed cost. This proactive approach can similarly benefit a firm’s domestic or international sales.

Foreign Currency Risk

Foreign currency risk is the risk that arises due to fluctuations in foreign echange rates. Firms with exposure to foreign exchange derivatives are also exposures to foreign currency risk. The objective of hedging foreign currency risk is to manage exposure to exchange rate fluctuations that affect future cash flows (revenues) as well as the fair value of assets and liabilities.

If a firm sells its products in foreign countries, then revenue hedging can be used with payment in the foreign currency. Here, the primary concern is related to the potential losses when converting foreign sales back into the firm’s domestic currency. To mitigate this risk, the firm can hedge some of its anticipated foreign currency receipts, taking into account the cost of hedging, as well as the volatilities and correlations of revenue and exchange rates. Instruments such as currency put options, which guarantee a minimum return if the exchange rate falls below the strike price, and forward contracts, which lock in an exchange rate in advance, can be used to secure a known return acceptable to the firm.

The major focus of the firm in heding its balance sheet exposures involves mitigating the effects of foreign exchange rate fluctuations on the net monetary assets of its foreign investments. For this purpose, forward contracts are commonly used as they allow the firm to lock in a fixed amount at a fixed exchange rate, offsetting the impact of rate changes on the net monetary assets. Foreign currency debt can also act as a natural hedge against a decrease in the value of a firm’s foreign investments.

Note: Hedging can sometimes be cost-prohibitive, leading firms to intentionally leave certain foreign currency positions unhedged.

Interest Rate Risk

Interest rate risk arises due to changes in market interest rates, affecting the cost of borrowing and lending. The aim of hedging interest rate risk is to manage the firm’s net exposure to adverse interest rate changes. To safeguard against potential losses from both investment and borrowing activities, firms can utilize interest rate swaps or swaptions. These instruments can also help minimize borrowing costs. Similar to the issue of high hedging costs mentioned earlier, some interest rate positions may be intentionally left unhedged.

Note: Firms can utilize interest rate swaps to hedge against this risk. An interest rate swap involves exchanging cash flows based on fixed and floating interest rates, allowing firms to manage interest rate exposure. For instance, a company with variable-rate debt can enter into an interest rate swap to convert it into fixed-rate debt, providing predictability in interest payments.

Static and Dynamic Hedging

A static hedging strategy involves a straightforward process where the risky investment position is initially determined, and an appropriate hedging instrument is used to closely match that position to minimize basis risk. Conversely, a dynamic hedging strategy is more complex, accounting for the changing attributes of the underlying risky position over time. To maintain the initial risky position with a dynamic strategy, additional transaction costs and significant time and monitoring efforts are required. Other important hedging considerations include:

1. Time Horizons: The firm must consider relevant time horizons for hedging and ensure performance evaluations align with these horizons.

2. Financial Accounting: The firm must assess the often complex financial accounting implications of hedging with derivatives. For instance, if the hedge does not exactly match the underlying position, gains or losses must be reported on the income statement.

3. Taxation: The taxation of derivatives significantly impacts the firm’s cash flows and varies between countries. Understanding the complex tax rules related tp derivatives requires substantial effort and cost, thus increasing the overall hedging cost.

Consider a multinational corporation (MNC) that imports raw materials from another country. The MNC expects to make a payment in a foreign currency three months from now. To hedge against potential currency fluctuations, the MNC enters into a forward contract with a bank. This contract locks in the exchange rate, ensuring that the MNC pays a predetermined amount in its domestic currency regardless of exchange rate movements.