Capital Budgeting with Hedging is Advantageous to a Firm Conducting Business in the International Business Environment Literature Review Large and drastic fluctuations in exchange rates pose a primary challenge to corporates firms operating in the current globally integrated market. Today’s business environment is complex, the competition most corporates face leads to artificial selection process whereby only organizations that can conform to the rule of the game play it for long. Otherwise, the unlucky ones who play the wrong economic cards bow out of the race unless they make quick survival decisions. As a result, most businesses are ever on the lookout for any risk and how they can shield themselves from such threats.
The economic risk-shielding tool of interest to this review is hedging. The paper reviews research papers authored Cong and Carter and their counterparts. Studies have been carried out to gauge how hedging affects the value of the firm. Specifically, the Carter, Rodgers, and Simkins considered how hedging influences the value of the U. S Airline Industry. According to their examination of the jet fuel hedging behavior in the U. S Airline Industry between 1992 and 2003, they noticed that jet fuel is hedgeable.
The financial and investment climate in the Airline industry conform to the theoretical frameworks. Carter and his colleagues discovered that the availability of airline investment opportunities correlates positively with the costs of Jet fuels (2006). On the contrary, higher prices of fuel are consistent with a small investment and reduced cash flows. From this study, it is remarkable that a firm that desires expansion and growth should consider hedging it purchases such as fuel in the future. Indeed, it is within these premises that the two airline companies, Airbus Group, and Delta, run their firms.
Cong et al. (2014) studied the scenario in the UK, based on interest rate hedging and the effect of foreign exchange on firms. They used UK data to evaluate the empirical evidence in debt and appraisal capacity influences of foreign currency and the hedging on interest rates. As opposed to Carter et al. (2006), it found the significant relationship between foreign currency, the value of the firm and interest rate hedging.
The outcomes are stronger that the results of the previous studies that have considered firm in the U. S. It is because studies carried out of U. S include non-hedging firms in their samples. The companies use non-derivative approaches for hedging that bias the outcome of the study. For this reason, the paper discusses two non-U. S airline companies that practice hedging. Rao (2011) realized that as a way to caution themselves against short-term risks of price volatility, the corporate firms have devised some of the best hedging methods they apply to their regular transactions.
Their study revealed that firms hedge risks primarily because the fluctuations threats are peripheral to the core business operation. Financial hedging helps the company through enabling it to lock its profits irrespective of the volatile exchange rates. That is to say, hedging is an optional side gamble, which entails adding to the profits made by rising exchange rates while subtracting the same value of benefits when the exchange rates are falling. If the company wishes to hold onto its gains when the exchange rates are down, it has to pay an optional premium to compensate the firm selling the hedge. Fiscal hedging can improve a company’s prospects by improving or maintaining its competitiveness.
It is true companies to exist in isolation but rather operates in a multi-player environment. Therefore, they compete both internally and externally. The companies that manage their risks well may use the stability to minimize their funding costs and resultantly lower their market prices that are strategic and critical to the future of the firm. The situation below is how a company may make a hedging decision.
Consider a European firm that sells 75% of its goods in U. S dollars ($) to its clients all over the globe. The company has just contracted a deal for $8 million worth of items and expects to receive payment in a months’ time. The company is undoubtedly exposed to exchange rate fluctuation since the payment is not immediate. If the company hedges the transaction by entering into a forward deal in which it will have to purchase Europe sterling pound (€) and sell $ for delivery on the similar date on the items contract.
That way the company can be sure of the exchange rates that it will use. However, it is a gamble because if the exchange rate does not change favorably the company loses. Nevertheless, if it is on the favorable side, then the company shields itself against the loss. Hedging is primarily a contingent plan. The recent reduction in oil prices that saw companies, which hedge, gain or lose depending on the nature of the contract. The temporary low oil prices that witnessed a shift in global operations had tremendous financial implications concerning the stock prices, the fuel prices and the general maintenance costs of most businesses among others.
Business Scenarios In U. S, some known corporations use hedging policy to guard risks. For example, the Airbus group has a currency hedge policy, on its website. The firm documents that it intends to generate profits not only from its operations and but also through speculations on foreign currency rates changes. Therefore, the company uses hedging strategies primarily to control and minimize the impact on its Earnings Before Interest and Tax (EBIT) from the instability of the U. S dollar ($) (Airbusgroup, 2015). Airbus enterprise has a long-term hedge portfolio with a maturity of many years that it uses to cover its net exposure to $ sales fluctuations.
Majorly it hedges in the operations of the Airbus, its helicopters, and its defense division. The company defines net exposure as the total firm audited currency, mainly US dollar-dominated incomes (Airbusgroup, 2015). Its hedging portfolio covers almost all its hedging transactions. From the hedging policy of Airbus Group, the primary aim is to ensure that the shareholders profits are increasing (2015). The case of Delta Airlines is a typical example of where hedging worked well for an airline firm.
The company has consistently hedged its costs of fuel to guard against the risk of oil price spikes. The strategy has proven to be counterproductive in the past nine months. Owing to the measure, oil prices have declined by $50 per barrel. Delta has incurred hedging losses (Simon, 2012). Although, the Airline Company experienced a rough time when employing the strategy, its hedging losses will shrink considerably within a short period.
Additionally, the company is expecting a total of 200 dollars million to 300 dollars in the second half of this financial year. The expected rates of the losses will bring its cost in line with the average prices of the industry in the first half of 2015. Using a proper hedging policy, Deltas all-in jet fuel value could be lowered to $2 per gallon, based on the current price of oil. By appraisal, Delta paid 2.90 dollars per gallon for jet fuel in Q3 2014 and 2.62 dollars per gallon in Q4 (Berghöfer & Lucey, 2014).
Judging from afar, hedging can be seen to have underlying advantages to the Delta Airlines. In conclusion, the tough decision of whether to apply hedging as accompany policy is an economic gamble that requires outstanding research before enforcement. Hedging just like another financial control tools has its benefits and disadvantages that warrant exploration. Otherwise, big firms use the fiscal measure to minimize probable financial risks they may incur in their operation. References Airbusgroup, (2015). Figures & Debt. Retrieved 29 April 2015, from http: //www. airbusgroup. com/int/en/investors-shareholders/Key-Figures-and-Debt. html Berghöfer, B., & Lucey, B.
(2014). Fuel hedging, operational hedging and risk exposure — Evidence from the global airline industry. International Review of Financial Analysis, 34, 124-139. doi: 10.1016/j. irfa. 2014.02.007 Carter, D. A., Rogers, D. A., & Simkins, B. J. (2006). Does hedging affect firm value? Evidence from the US airline industry. Financial Management, 35(1), 53-86. Retrieved from http: //search. proquest. com/docview/208191035?accountid=8067 Cong, J., Tan, K. S., & Weng, C. (2014). Conditional value-at-risk-based optimal partial hedging. The Journal of Risk, 16(3), 49-83. Retrieved from http: //search. proquest. com/docview/1627689996?accountid=8067 Ir. delta. com, (2015). Delta Air Lines, Inc. - News & Events - News.
Retrieved 29 April 2015, from http: //ir. delta. com/news-and-events/news/default. aspx Rheinländer, T., & Sexton, J. (2011). Hedging derivatives. New Jersey: World Scientific. Simon, D. (2012). The Intraday and Overnight Behavior of SPY Options and Adjusted Delta Hedging. J. Fut. Mark. , 33(5), 443-468. doi: 10.1002/fut. 21558