Question

Discuss four (4) ways that the losses sustained by the firms are related to their hedging efforts. (Finance question)

Answer 1

The three most common ways where companies use derivatives for hedging include foreign exchange risks, hedging interest rate risk, and commodity or product input hedge. These derivatives help to protect the company from unanticipated events: adverse foreign exchange or interest rate movements and unexpected increases in input costs.

There are several reasons why firms may choose to hedge risks, and they can be broadly categorized into five groups. First, the tax laws may benefit those who hedge risk. Second, hedging against catastrophic or extreme risk may reduce the likelihood and the costs of distress. Third, hedging against risks may reduce the under investment problem prevalent in many firms as a result of risk averse managers and restricted capital markets. Fourth, minimizing the exposure to some types of risk may provide firms with more freedom to fine tune their capital structure. Lastly, investors may find the financial statements of firms that do hedge to be more informative than firms that do not.

1. Tax Benefits - A firm that hedges against risk may receive tax benefits as against a similar firm that does not hedge against risk. There are two sources for these tax benefits. One comes from the smoothing of earnings that is a consequence of effective risk hedging; with risk hedging, earnings will be lower than they would otheriwse have been without hedging, during periods where the risk does not manifest itself and higher in periods where there is risk exposure.The other tax benefit arises from the tax treatment of hedging expenses and benefits. There will be a tax benefit to hedging if the cost of hedging is fully tax deductible but the benefits from insurance are not fully taxed.
2. Better investment decisions - By allowing managers to hedge firm-specific risks, risk hedging may reduce the number of good investments that get rejected either because of managerial risk aversion or lack of access to capital.
3. Distress Costs - Every business, no matter how large and healthy, faces the possibility of distress under sufficiently adverse circumstances. Given the large costs of bankruptcy, it is prudent for firms to protect themselves against risks that may cause distress by hedging against them. Generally speaking, these will be risks that are large relative to the size of the firm and its fixed commitments (such as interest payments). For example, while large firms with little debt like Coca Cola can easily absorb the costs of exchange rate movements, smaller firms and firms with larger debt obligations may very well be pushed to their financial limits by the same risk. Consequently, it makes sense for the smaller firms to hedge against risk.
4. Capital Structure - In general, firms that perceive themselves as facing less distress costs are likely to borrow more. Additional borrowing creates a tax benefit, this implies that a firm that hedges away large risks will borrow more money and have a lower cost of capital. The payoff will be a higher value for the business.

A significant number of firms hedge their risk exposures, with wide variations in which risks get hedged and the tools used for hedging. While a significant proportion of firms hedge against risk, some risks seem to be hedged more often than others.