Question

A) Define a long hedge and a short hedge and give examples of each kind of hedge and what are the benefits of a corporation’s hedging?

Answer 1

A.)

Long Hedge

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Example of a Long Hedge

In a simplified example, we assume that it is January, and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $2.50 per pound, but the May futures price is $2.40 per pound. In January the aluminum manufacturer would take a long position in a May futures contract on copper.

This futures contract can be sized to cover part or all of the expected order. Sizing the position sets the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the hedge ratio is 50%. If the May spot price of copper is over $2.40 per pound, then the manufacturer benefited from taking a long position. because the overall profit from the futures contract helped to offset the higher purchasing cost paid for copper in May.

If the May spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures position while saving overall, thanks to a lower-than-anticipated purchasing price.

Short Hedge

A short hedge is an investment strategy used to protect (hedge) against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell. A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Firms in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The firm seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.

Example of a Short Hedge

Let's assume it's October and Exxon Mobil Corporation (XOM) agrees to sell one million barrels of oil to a customer in December with the sale price based on the market price of crude oil on the day of delivery. The energy firm knows that it can comfortably make a profit on the sale by selling each barrel for $50 after considering production and marketing costs.

Currently, the commodity trades at $55 per barrel. However, Exxon believes it could fall over the next few months as the trade war between the United States and China continues to pressure global economic growth. To mitigate downside risk, the firm decides to execute a partial short hedge by shorting 250 Crude Oil Dec. 2019 Futures contracts at $55 per barrel. Since each crude oil futures contract represents 1000 barrels of crude oil, the value of the contracts is $13,750,000 (250,000 x $55).

At the time of delivery to the customer in December, the oil price has fallen and now trades at $49. Exxon consequently covers its short position for $12,250,000 (250,000 x $49) with a profit of $1,500,000 ($13,750,000–$12,250,000). Therefore, the short hedge has offset the sale's loss caused by the decline in the oil price.

Benefits of hedging

Most CFOs and Treasurers are aware of the financial benefits of hedging FX exposures, and hedging FX is a widespread practice (93% of the Fortune 500 hedge FX ). However, not much thought is given to the strategic benefits of hedging. These include increased pricing stability, corporate valuation, an enhanced ability to raise both debt and equity capital, reduced taxation, and reduced uncertainty when entering new markets.

Enhanced price stability

Creating price stability is an obvious advantage of hedging. The benefits manifest in two ways. For goods that are imported for sale, it lowers volatility in the cost of goods sold (COGS). For goods that are sold in foreign markets, hedging offers the ability to maintain a stable price in local currency, increasing competiveness with local firms. Both can raise the present value of future earnings.

When a company is operating in a regulated market, additional opportunities to enhance competitiveness may exist. For example, in the Philippines, where GDP growth is outstripping energy generating capacity, government regulations (i.e. Electric Power Industry Reform Act, EPIRA) control energy pricing. Because a large (45%) percentage of oil is imported, and oil is priced in USD, EPIRA allows the passing of exchange rate effects on to consumers. Because the local price is a combination of USDPHP and USD/bbl oil, price swings of up to 35% over a few months are possible. If the energy company hedges its fuel costs, it will be allowed to pass on fuel cost increases that it is not experiencing (but its competitors are!), enhancing profitability.

Higher corporate valuations

The positive impact of hedging on corporate valuation is a strongly-confirmed effect. The reason is salutary effects of earnings stability on multiple corporate measures. A 2001 paper found that hedging increases Tobin's Q substantially. Tobin's Q value is defined as:

(Equity Market value + Liabilities Market Value ) / (Equity Book Value + Liabilities book value )

A value greater than 1.0 indicates the market value reflects unmeasured or unrecorded assets of the company. If a company's stock price (which is a measure of the company's capital market value) is $2 and the price of the capital in the current market is $1, the company can issue shares and profitably invest the capital. Other researchers have found a statistically significant hedging "premium" (added firm value due to hedging) of between 5-10%.

More subtle reasons for the added firm value are from the increase ability of the firm to borrow and invest, given more stable cash flows. A study on corporate hedging and value showed that derivative users have valuations that are 6.7-7.8% higher than non-user firms. Finally, some research has indicated that hedging firms usually are better able to meet or exceed analyst's expectations. Higher valuations enhance a company's acquisitions, sales and divestitures capacity. If the firm's valuation is higher because of hedging, then its ability to acquire other companies is enhanced. Additionally, if debt is also used in an acquisition, hedging enables higher leverage and lower credit spreads

Enhanced ability to raise capital

The ability of a firm to raise capital for expansion and investment increases with hedging. There are two main sources of funds to a company - the equity market, and the debt market. The equity market makes investment decisions based on many factors, but one of them is the well-known Sharpe Ratio. This ratio (ex-ante) is calculated as follows:

S(p) = E[R(a) – R(b)]/√var[R(a) – R(b)]

this means take the expected value of the rate of return minus the risk free rate, and divide that result by the standard deviation of the return. It shows how the return compensates the investor for the risk taken (standard deviation). Because reducing earnings variation will reduce the standard deviation, hedging raises the Sharpe ratio for any level of earnings, and thus the attractiveness to investors.

In the debt market, a firm's ability to borrow is increased when it hedges. This is because the firm's ability to repay the debt is more assured when its cash flows are more stable. This intuitive conclusion is borne out by research which shows hedging increases allowable debt ratio by 3.03% or more . A key metric of corporate credit is net foreign exchange exposure to equity. When FX exposures are hedged, this metric improves.

Companies always hedge transactional risk, which includes translational risk of monetary assets. However, the decision to hedge non-monetary assets (e.g. FF&E of a foreign subsidiary) may hinge on additional factors. There is a significant effect hedging non-monetary assets can have on debt and reserves, and thus on gearing and, in turn, on compliance with covenants. Critical ratios such as debt to equity must be maintained to avoid triggering net worth covenants and paying higher credit spreads. Thus, hedging nonmonetary foreign assets may enable lower credit spreads. It should be kept in mind that hedging nonmonetary assets creates cash flow impacts. There is a trade-off between balance sheet and income statement effects that should be considered.

Reduced taxation

There are two benefits that hedging has on taxation. The first is tax convexity. The function that maps income into tax liability is convex for most companies. It can be shown (by Jensen's Inequality ) that firms can expect to reduce their tax liability from reduced income volatility through hedging. The second contribution is the effect of increased debt capacity and the tax deductibility of interest. This effect is much larger than convexity. Leverage has a positive influence on both IR and FX derivatives. For the average firm, hedging with currency derivatives increases the available debt ratio by 4.52%, with the capitalized value of the incremental tax shields resulting from this increased debt equaling 1.4% of firm value .

New market entry

Expansion into new markets, whether developed or emerging economies, carries with it increased exposure to foreign exchange volatility. While regions such as China, Brazil, India, Mexico and the Philippines offer large and growing populations, their respective currencies are usually quite volatile. To ensure that revenue forecasts and projections are not sunk by adverse currency moves, long-term hedging solutions are indicated.

A corporation must make use of natural hedging opportunities, which carry no premiums and are not limited in tenor. For example, when a company is exporting to a new market, natural hedges should create offsetting expenses. This include establishing local personnel, offices and warehousing, and local currency debt. To the extent that natural hedges are insufficient to hedge the exposure completely, derivative cash flow hedges can then be used. Many firms extend the horizon of their cash flow hedging programs as long as 18-24 months; as far as they believe they need to before being forced to reprice in the market.

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