Risk and uncertainty

Risk and uncertainty is natural in all organisational activities. Therefore getting a general idea of what is risk will give an indication why it needs to be managed. As defined by the Risk of Management Standards (2002), a risk is a set of probabilities of an event occurring and its likely consequences. This definition of risk is not of much help in defining what risk is actually, but in an organisational context, this refers to risk as having a possible adverse effect on the performance and is treated mostly as a threat.

Risk Management and Hedging

Many corporations are experiencing increasing costs due to risk. Risk may create a crisis in acompany. Boodman (1987) states that: “Risk management has not been prepared to meet current risk environment”. Even if this definition is about 22 years old, it is still valid. Recent corporate failure such as General Motors, which was ranked as the 18th largest entity on the planet in 2008, indicates the dynamic and turbulent nature of the business environment does not change. Uncertainties in the global market coupled with concerns about the effectiveness of corporate governance make risk management necessary for organisations. Kallman and Maric (2004) defines risk management as:

“A specialised discipline intended to provide decision makers with a scientific method to create the desired variation from an expected outcome at some time”

Financial institutions and corporations thus turn to hedging so as to create this desired variation. Hedging lessen a firm's exposure to risk by taking an offsetting position in a security, commodity or currency (Kallman and Maric 2004). In simpler terms, hedging implies that firms are able to transfer their risks through the use of derivatives products. It must be noted that risk management does not eliminate all the risks associated with the firm but simply try to manage and chose between risks so as to hedge the most urgent ones.

Following the work of Kimball (2000), hedging should not be considered too lightly by management. In fact, there must be a constant monitoring of hedging policies and procedures. The reason main reason is that ‘risk management may fail due to a degradation of the process.’ The inadequate attention given to the system may result in organisation becoming unconcerned to the risks surrounding the business activities. Managers believed that they have mastered the concept of risk, thus causing an increase to exposure of firms.

However, the problem that many organisations faced is whether or not to engage in a hedging activity, which risks must be hedged and which one must be beared, and by how much to hedge. The selection of an appropriate hedging tool may also be seen as a challenge to management. This implies that a good hedging plan must be implemented before engaging in any hedging activity such that corporations are able to balanced the benefits of protection against the cost of hedging, thereby achieving the optimal risk profile.

Derivatives as Hedging Tools

A derivative is a financial instrument which derives its value from the value of some other financial instrument or variable. Derivatives instruments, also known as off balance sheet instruments, include forward contracts, futures, options and swaps. Derivatives are used mainly for hedging purposes, speculative purposes or arbitrage pricing. From a risk management context, the use of derivatives may result either in an opportunity arising to make gains or the risk of substantial losses. These off balance sheet instruments act as an insurance against changes in commodity prices, exchange rates and interest rates, thereby protecting the volatility of cash flows.

Forward

A forward contract is a bilateral agreement between two parties which states the term of an exchange of an asset taking place between them at a later date. The contract contains the following specifications:

What is being exchanged,
The price and,
The date when the exchange takes place

The delivery as well as the money being transferred arises at the specified date rather than an immediate or spot delivery. A forward contract is tailor made so as to meet the requirements of the two parties. It must be noted that it not very liquid and cannot be transferred to a third party.

A simple rational behind the forward is, for instance, if the spot price is higher than the future price; the party taking the delivery gains. One big disadvantage with a forward contract is that it involves a credit risk whereby one counter party may default. An example of a forward contract is trading commodities or foreign currencies.

Futures

Futures contracts are standardized agreements to exchange specific types of assets, in specific amount and at a specific future maturity dates. This implies that the contract is non negotiable. Compared to a forward contract, the futures contract being standardised makes it very liquid and can be exchanged freely between counterparties. Moreover, futures are traded on a regulated exchange, known as a clearinghouse, which guarantees that all contracts are fully fulfilled by both parties, therefore eliminating credit risks. The Clearinghouse makes use of a system known as market to market in settling profits and losses of counterparties daily.

Futures also require an initial margin, usually from 5% to 10% of the contract value, whereby each counter party makes a deposit, from which the resulting loss experienced by one is deducted and the sum is transferred to the other counterparty. A maintenance margin implies that whenever the initial margin drops below a certain level, the counterparty has to make a payment to restore the account, thus minimizing credit risks.

Options

An option is a contract that gives the right, but not the obligation, to perform a specified transaction with another party at a fixed price at a future date. Two of the most common form of options is:

A call option that gives the holder the right but not the obligation to buy the
underlying asset by a certain date for a certain price.
A put option gives the holder the right but not the obligation to sell the underlying
asset by a certain date for a certain price.

An example may be a corporate bond that has an option provision allowing the issuer to purchase the bond back from the purchaser five years prior to maturity for a specified price.

Stand-alone options trade on exchanges or an OTC (Over the Counter). An instrument is traded OTC if it trades in some context other than a formal exchange. Most debt instruments are traded OTC with investment banks making markets in specific issues. Most exchange-traded options have stocks or futures as derivatives. OTC options have a greater variety of derivatives, including bonds, currencies, commodities, swaps, or baskets of assets. Options can be embedded in almost any contract.

Swap

A swap is a cash-settled OTC derivative. Swaps are the simplest form of OTC derivative, with the exception of forwards.

A swap is an agreement between two counterparties to exchange two streams of cash flows, whereby the parties “swap” the cash flow streams. Those cash flow streams can be defined in almost any manner. All that matters is that their present values be equal. While swaps are used for various purposes, their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability. For example, an investor realizing returns from an equity investment can swap those returns into less risky fixed income cash flows without having to liquidate the equities.

When a swap is first entered into, it has zero market value. This is because both cash flow streams have identical, offsetting market values. As time goes by, the swap is likely to take on a positive or negative market value. This may happen for the following reasons:

Market variables that affect the market values of one or both cash flow streams will
fluctuate, causing the values of the cash flow streams to change. The swap's market
value, which is simply the difference between the two cash flow streams' market
values, will then also change.
One cash flow stream may have more accelerated payments than the other, so the
swap takes on a positive market value for the party making the more accelerated
payments. An extreme case of this is some customized swaps that require one party to
make a substantial payment right at the outset.

For the first of the above reasons, swaps entail market risk. For both reasons, they entail pre-settlement risk. Collateralization is a common way of addressing pre-settlement risk of one or both of the counterparties. Settlement risk can be a problem for some swaps. However, cash flow streams are often structured so that payments for one occur on the same dates as payments for the other. This allows cash flows to be netted against each other, as long as the cash flows are in the same currency.

A vanilla swap is any swap with fairly standardized provisions. The term is usually applied to vanilla interest rate swaps or vanilla currency swaps. Vanilla swaps are appealing because pricing tends to be transparent and transaction costs are small. Vanilla swaps can be used to speculate or to quickly hedge the market risk of a position without necessarily offsetting the specific cash flows of that position.

Swaps can also be customized to offset the specific cash flows of a position. Dealers often structure such non-vanilla swaps for clients. They may charge a fee for doing so, and pricing may reflect a large bid-ask spread. An asset swap is a non-vanilla swap customized to change the character of a specific asset. A liability swap is such a swap customized to change the character of a specific liability.

Swaps are also categorized according to the nature of the cash flow streams being exchanged.

Hedging and Financial Risks

The main objective of any hedging strategy is to offset any adverse effects that financial risks may have on a firm. Integrating risk management in the financial sense is concerned with employing debt, equity and financial derivatives in a coordinated manner to manage the organisation's overall financial position. (Ward 2003). Market-wide risks are associated with the economic environment in which all companies operate, where changes in interest rates, currency exchange rates and commodity prices affect all companies. These risks can only be managed through the use of derivatives. Financial risk management is a process of changing the methods of financing within a company, largely to address market-wide risks. Therefore, it involves identifying the type of risks the company is exposed to in the course of its business and address them through a proper hedging strategy.

Interest Rate Risk

Companies having debt face the problem of interest rate risk. Its volatile nature implies that firms must be aware of the risks that represent the movement of interest rate. Interest rate risk is the risk to the profitability of a company resulting from changes in interest rates.

A company that borrows or invests surplus funds does so at either a fixed rate of interest or at a floating rate. Fixed rates provide certainty as interest payments or receipts are known regardless of future interest-rate movements. However, there are also risks associated with fixed-rate debts. For long-term debts the company risks being locked in to a high interest rate if interest rates fall during the duration of the loan.

A floating-rate borrowing or investment varies through the duration of the loan or investment. Floating rates are usually expressed as a margin over an agreed reference rate and are reset at regular intervals. Changes in short-term interest rates can have a significant impact on the interest paid on a floating rate debt. While rising interest rates increase the cost of borrowing, falling interest rates reduce interest income from the investment. Thus, although a floating-rate debt provides some flexibility, the company may lose out if interest rates rise. The impact of interest rates on the business will depend on the choice of funding, that is, the mix between capital and debt; the mix between fixed and floating rate debt; and the mix between short-term and long-term debt.

Commodity Price Risk

Commodity price risk refers to the risk that an unexpected change in the price of a commodity have on cash flows and the market value of a firm. A simple example is the changes in the price of oil may have either a positive or negative effect on the cash flow of an airline company. This change might occur due to changes underlying supply and demand; that is changes in real prices and changes in the nominal price level.

Foreign Exchange Rate Risk

Exchange rates tell us how many units of one currency may be bought or sold for one unit of another currency. The spot rate is the exchange price for transactions for immediate delivery. The forward rate applies to a deal which is agreed upon now but where the actual exchange of currency is not due to take place until some future date. The exchange of currencies at the future date will be at the rate agreed upon now. Currency volatility is a major risk faced by companies doing business outside their home countries.

Exchange rate risk occurs as a result of either transaction risk or economic risk. Transaction risk occurs from the effect of changes in nominal exchange rates that affect a company's contractual cash flows in foreign currencies. It relates to contracts already entered into but which have yet to be settled. Thus, a company is subject to transaction risk whenever it imports goods from or export goods to another country which are paid at a later date, or where a company borrows or invests in a foreign currency or uses derivatives denominated in a foreign currency.

Economic risk refers to the degree to which the value of the firm's future cash flows can be influenced by exchange rate fluctuations. These are essentially the risks which affect a business before a transaction actually takes place, and are not therefore measurable. Even companies that trade only in their home country may be subject to economic risk if they face foreign competition within their local markets. Companies can lose competitiveness if their home currency appreciates against its major competitors. Economic risk involves the effect of exchange rate changes on expected future cash flows from the company's operations. It is sometimes referred to as competitive risk and it is an important risk, from the long-term perspective of the company.

Credit Risk

Credit risk is the uncertainty to which a counterparty's ability to meet its obligations as they become due. This risk can be eliminated by trading with parties through a well regulated exchange market.

Liquidity Risk

Liquidity risk is the risk that a company will be unable to meet its obligations as they come due because of an inability obtain adequate funds. The company can mitigate this risk by a careful cash flow planning.

The Rationale behind Risk Management

There are many theories that have been put forth that have been applied for risk management, from Miller and Modigliani (1963), through Smith and Stulz (1985) along with many others, up to now. However, it may be rather difficult to find a consistent result amongst authors for the true rationale behind hedging. Klimczak (2008), argues that many empirical studies previously done have failed in determining ‘which theories are supported by empirical observation of corporate hedging and which are not.’

According to Jin and Jorion (2006), there exist two types of theories that put forward a basis for corporations to undertake risk management activities. The first theory is based upon shareholder value maximisation while the other one is managerial motives.

Shareholder Value Maximisation

For the shareholder maximisation theory, it argues that most firms engage in hedging activities due to the volatile nature of cash flows, that is, the high degree of costs which makes earnings unstable. Three main explanations are put forward to support this view. First of all, hedging may be found to reduce the cost of financial distress of companies (Smith and Stulz, 1985). Financial distress implies a situation whereby a firm is unable to meet the cost of its debt; as such there will be some bankruptcy costs in the increasing financing from debt instead of equity. Thus, hedging makes it possible to increase the debt capacity of the firm as the latter is able do decrease the uncertainty surrounding its future ability to meet the repayment of these debts, thus decreasing the bankruptcy costs.

The second view implies that firms are motivated to hedge due to tax incentives. Smith and Stulz (1985) find that a firm facing a convex tax function of earnings should be able to reduce its expected tax liability by reducing the variability of its earning. This logic states that the more unpredictable is earnings the greater is tax than a less unpredictable earnings due to the convexity. Moreover, the more convex is the tax schedule, the greater will be reduction in expected taxes. This theory is based on a firm facing increasing marginal tax rate. Also, as firms are able to increase their debt capacity from hedging, this may act as a tax shield,

The last explanation that supports this theory is that the problem of underinvestment is eliminated. Froot et al. (1993) based this assumption on the variability of cash flows if a firm does not hedge, which may be because of market imperfections. The rationale is that underinvestment might occur if the cost of obtaining outside capital is high while a low cash flow prevents the firm to invest when the opportunity arise. For example, new aircraft purchases are planned years in advance. Thus, hedging preserves internal cash flow so as to be able to meet future commitments. By eliminating the variability of cash flows, hedging helps to have access to cheap capital, that is internal funds, whenever a growth opportunity arises by reducing the influence of external sources of financing that may have on a company's investment decision.

The first explanation put forward by Smith and Stulz (1985) emphasize on the fact that hedging helps distressed firms. Haushalter (2000) finds similar results supporting this theory, whereby he states that hedging and financial leverage having a positive relation. However he does not find any relation between the motives behind hedging and tax convexity. Similarly, Graham and Rogers (2002) argue that while tax savings does not appear to trigger hedging, the latter does increase debt in the capital structure. Moreover, they find that the incremental tax benefits due to the additional debt may amount to about $30million for an average firm. Finally, Carter et al. (2002) prove that hedging eliminates the risk of underinvestment. During periods of high jet fuel prices, hedging permit airlines to fund investments opportunities.

Managerial Motives

According to Smith and Stulz (1985), risk averse managers prefer to take actions in reducing the variability of the firm's return. From this argument it may be found that managers have more incentives in managing a firm's risk if they have wealth invested in its equity. Moreover, outside investors view managerial ability through hedging (DeMarzo and Duffie, 1995). Thus, the results show that managers are more concerned at protecting their jobs.

Impact of Hedging

There is a mixed view in the studies made that supports the shareholder value maximisation theory in the sense that it increases a firm's value. Froot et al. (1993) argue that the extent to which a firm is able to eliminate underinvestment and manages its low cash flow from hedging increases its value. Similarly, Carter et al. (2002) demonstrate the positive relation between hedging and value increase in capital investment. The value of an airline company is directly related to jet fuel hedging, such that there is a hedging premium that constitutes about 12% to 16% increase in the value of the firm.

Stulz (1996) proposes the selective hedging practice, implying that firms will engage in hedging activities only if they anticipate unfavourable events, while they will unload their futures when outlook seems more favourable. This informational advantage makes the firms more competitive as they are able to predict more precisely input and output price movements. Therefore, selective hedging increases the firms' value.

However, some other views conclude that there is no relation between a firm's value and hedging, and even if there is it is rather insignificant to increase this value (Guay and Kothari 2003). They further states that either this increase in market value is due to other operational hedges or that the result is a fake one. Further more, Jin and Jorion (2006) find proof that there is no positive relation between hedging and market value.

As for the managerial motives theory, Jin and Jerion (2006) states that hedging should not affect the market values of firms.