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Corporate Risk Management: A Primer

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FRMFinancial Risk Manager

Hedging Risk Exposures


Evaluate some advantages and disadvantages of hedging risk exposures
Disadvantages

There are some theoretical reasons for a firm not to hedge risk exposures but most of
those reasons make the unrealistic assumption of perfect capital markets, which is not
realistic. Also, they ignore the existence of the significant costs of financial distress
and bankruptcy. However, in practice, there are some valid reasons not to hedge,
including the distraction from focusing on the core business, lack of skills and
knowledge, and transaction and compliance costs.

Advantages

Many reasons exist for a firm to hedge its risk exposures. Key reasons include
lowering the cost of capital, reducing volatility of reported earnings, operational
improvements, and potential cost savings over traditional insurance products.

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Hedging Decisions
In hedging specific risk factors, it is necessary to consider the role of the board of
directors as well as the process of mapping risks. The board, together with
management, should set the firms risk appetite using one or more of the following
tools: qualitative statements of risk tolerance, value at risk, and stress testing. Risk
management goals must be clear and actionable and there should be clarification
whether accounting or economic profits are to be hedged. Likewise, there should be
clarification whether short-term or long-term accounting profits are to be hedged.
Other points the board should consider include the time horizon and the possibility of
implementing definitive and quantitative risk limits.
Mapping risks requires clarification as to which risks are insurable, hedgeable,
noninsurable, or nonhedgeable. Mapping risks could be performed for various risks
such as market, credit, business, and operational. Essentially, it involves a detailed
analysis of the impacts of such risks on the firms financial position (balance sheet)
and financial performance (income statement).
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FRMFinancial Risk Manager

Hedging Operational and Financial Risks


Hedging operational risks covers a firms activities in production (costs) and
sales (revenue), which is essentially the income statement. Financial position risk
pertains to a firms balance sheet. Making the realistic assumption that there are
some imperfections in the financial markets, a firm could benefit from hedging
financial position risk. Hedging activities should cover both the firms assets and
liabilities in order to fully account for the risks.

Pricing Risk

With production, the cost of inputs may have a significant impact on the firms ability
to conduct its business in a competitive manner. Therefore, it makes sense to hedge
such pricing risk by purchasing a forward or futures contract to buy a specific quantity
of that input at a fixed cost determined in advance. The same could be done with a
firms domestic or foreign sales, as will be discussed next.

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FRMFinancial Risk Manager

Hedging Operational and Financial Risks


Foreign Currency Risk

The goal of hedging foreign currency risk is to control exposure to exchange rate
fluctuations that impact future cash flows and the fair value of assets and liabilities.

Revenue hedging can be used when a firm has sales to customers in foreign countries
(with payment in the foreign currency). There is the risk of the devaluation of the
foreign currency in the future, resulting in losses to the firm when the funds are
ultimately converted back to the domestic currency.

Interest Rate Risk

The goal of hedging interest rate risk is to control the firms net exposure (asset or
liability) to unfavorable interest rate fluctuations.

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FRMFinancial Risk Manager

Static vs. Dynamic Hedging Strategies


A static hedging strategy is a simple process in which the risky investment
position is initially determined and an appropriate hedging vehicle is used to
match that position as close as possible and for as long as required.

In contrast, a dynamic hedging strategy is a more complex process that


recognizes that the attributes of the underlying risky position may change with
time. Assuming it is desired to maintain the initial risky position, there will be
additional transaction costs required to do so. Significantly more time and
monitoring efforts are required with a dynamic hedging strategy.

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Risk Management Instruments


Once the risks are mapped, management and the board need to determine which
instruments to use to manage the risks. The relevant instruments can be classified
as exchange traded or over the counter (OTC).

Exchange-traded instruments are generally quite standardized and liquid.


OTC instruments are more customized to the firms needs and therefore less
liquid. An element of credit risk is also introduced with OTC instruments.

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FRMFinancial Risk Manager

Example
1.

Melody Li is a junior risk analyst who has recently prepared a report on the
advantages and disadvantages of hedging risk exposures. An excerpt from her
report contains four statements. Which of Lis statements is correct?
A.

Purchasing an insurance policy is an example of hedging.

B.

In practice, hedging with derivatives is not likely to be a zero-sum game.

C.

The existence of significant costs of financial distress and bankruptcy is


considered within the assumption of perfect capital markets.

D.

Hedging with derivatives is advantageous in the sense that there is often the
ability to avoid numerous disclosure requirements compared with other
financial instruments.

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Example
1. Answer:

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Example
2.

The involvement of the board of directors is important within the context of a firms
decision to hedge specific risk factors. Which of the following statements regarding
the setting of risk appetite is correct?
I.
Risk appetite may be conveyed strictly in a qualitative manner.
II.
Debtholders and shareholders are both likely to desire minimizing the firms
risk appetite.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

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FRMFinancial Risk Manager

Example
3.

Lear, Inc., is a U.S. wine producer that purchases a significant amount of cork (
) for its wine bottles from Asia. It also sells much of its wine to customers
throughout North America. Based on these two broad transactions, which of the
following risks does Lear, Inc., most likely face?
A. Financial position risk and operational risk.
B. Operational risk and pricing risk.
C. Pricing risk only.
D. Financial position risk, operational risk, and pricing risk.

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FRMFinancial Risk Manager

Example
4.

Which of the following statements regarding exchange-traded and over-thecounter (OTC) financial instruments is correct?
A.

There is greater liquidity with exchange-traded financial instruments.

B.

There is greater customization with exchange-traded financial instruments.

C.

There is greater price transparency with OTC financial instruments.

D.

There is credit risk by either of the counterparties inherent in exchangetraded instruments.

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FRM

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