Risk And Hedging

Hedging exposures, sometimes called risk management or exposure management, is widely resorted to, by finance directors, corporate treasurers and portfolio managers. The practice of covering exposure is designed to reduce the volatility of the firms’ profits and/or cash generation and it follows that this will reduce the volatility of the values of the firm. Hedging to reduce overall variability of cash flow and profits may be important to managers, compensated accordingly to short-term results, but it is irrelevant to diversified shareholders. The ups and downs of individual investments are compensated by holding a well diversified portfolio.  Hedging market are wholesale markets and corporate hedging may, therefore, be cheaper.  Hedging requires information about current and future exposures and contingent exposures too and it is doubtful whether investors have anything like.  Hedging device is a firm may be able to reduce or eliminate currency exposure by means of internal strategies or invoicing arrangements like risk sharing between the firms and its foreign customers. Another non-market based hedging possibility is to work out a currency risk sharing agreement between the two parties i.e. exporter and importer.

The following are the Reasons to hedge

• Removing unsystematic risk by the firm is cheaper than investors doing it -
  • Especially internationally
  • Transaction costs may be significant for individuals
• Financial distress
  • Firms in financial distress face both direct costs (bankruptcy costs) and indirect costs (loss of customers, suppliers, and employees).
  • Hedging can reduce the probability of financial distress and thereby lower the expected costs of distress.
  • By lowering the probability of the firm getting into trouble, it makes customers, suppliers, etc. more willing to deal with the firm. _ This should increase cash flows and raise the value of the firm.
• Agency conflicts
  • Previously discussed bondholder/stockholder conflicts.
  • Firms those are stable with low probability of large variances in income have no worry about such conflicts. But firms with income that is highly variable are exposed to the costs of such conflicts (harder to monitor or see why cash flows are low).