Question

Explain to your non-technical client how the practice of financial risk management is similar to hedging, and how is it different.

State and discuss the reasons why Qantas should hedge and why it shouldn’t hedge its fuel costs.

Answer 1

Financial risk management identifies, measures and manages risk within the organisation’s risk appetite and aims to maximise investment returns and earnings for a given level of risk. It does this in several ways.

• Reducing cash flow and earnings volatility.

• Managing the costs of financing costs (e.g. through the use of derivatives).

• Increasing the value of a company’s shares. By reducing financial volatility, it can lower shareholders’ rate of return and thus the cost of capital which can increase profits and value of a company.

• Management of operating costs by managing fluctuations.

An organisation must identify and understand its financial risk exposures, including the significance of these risks.By its nature, risk is uncertain and putting a value on risk exposure will never be exact. However, it is important to measure the financial impact of the risk factor on either the value of the company or individual items such as earnings, cost or cash flow. This will determine if it is necessary to do something about managing against the risk. Techniques used to quantify exposures include standard deviation (the most straightforward method), regression analysis, simulation analysis and value at risk (VaR). In practice, it depends on the nature of the risk but using more than one method is usually recommended.

Hedging is to decide whether to hedge each of the significant exposures. This decision is based on factors such as the goals/objectives of the company, its business environment, its appetite for risk and whether the cost justifies the reduction in risk. Strategies for managing exposures may include one or more of the following:

a. Accept the risk (i.e. do nothing) where the cost does not justify action. b. Manage the risk using internal operating techniques. These should be used in preference to derivatives, especially as many exposures are completely or partly offsetting and do not involve transaction costs.