Corporate Hedging, Firm Risk and Firm Value - Assignment Example

1. Executive Summary Business by virtue of their dynamic nature is prone to risks. Risk can originate from anywhere. The factors can either be internal and operations based or can be it can be external or environmental driven. Though there are instruments available at the helm of a financial manager to gauge and mitigate the risk involved, it is sophisticated enough to use it judiciously. A derivative is one such financial instrument which derives its value from some underlying asset. It is one of the most popular financial instruments to hedge financial risk. Business can never run on mere whims and fancies of a financial manager. Thus one need to estimate in advance the outcomes and risk involved with the business. The process of taking preemptive steps to curb the ill effects of risks is indeed called as hedging. There can be very many ways to do that. But as a matter of fact it is never possible to completely avoid or curb any risk. Risk by definition is a possibility and that can never be estimated with surety. It is often argued among various research papers that there exists a relationship between the derivative used for hedging and the value of the firm. There are arguments and counter arguments in this concern. Moreover there are also a debatable relationship between the derivatives used for hedging and the market risk exposure of any firm. This assignment endeavors to logically explore such stand points and come up with a reasonable conclusion in this concern. Moreover it will also briefly touch the basic fundamental involved with derivative and hedging as used and adopted by different organization. 2. Introduction: Why’s and how’s Derivatives being at the realm of advance technical finance, is considered a mystery term. Technically speaking, the concept of derivatives, hedging, firm valuation and risk exposure are the terms which are not in common league of investors and thus are considered complex. The following explanations will try to ease off any such complexity. 2.1. Derivatives A derivative can be defined as the financial instrument having certain value which is derived from or stems from a principal underlying asset or set of assets. A derivative's value is derived off a spot price time-series of an asset but as far as the ownership of a derivative is concerned, it doesn't warrant ownership of the underlying asset or set of assets. The derivative in itself is merely an agreement between two or more parties. The value of a derivative keeps on fluctuating and can be determined by fluctuations in the underlying asset. The examples of the frequently used underlying assets are stocks, bonds, commodities, currencies, interest rates and market indexes. Almost all derivatives are regarded as by highly leveraged.  Derivatives are generally used as a risk hedging instrument, but can also be used for speculative rationale Warren Buffett, the world fame investor, once called derivatives, "financial weapons of mass destruction". But as a matter of fact derivatives can be very constructive instrument, provided they are used appropriately. Like any other financial instruments, derivatives too have their own set of pros and cons. Derivatives also have in it an exceptional prospective to augment the functionality of the financial system as whole. 2.2. Types of Derivatives As discussed earlier derivatives are the contracts between two or more parties. The most common kinds of derivative contracts used are namely forwards, futures and options. Given below is a brief outlook of these. 2.2.1. Forwards: A forward contract is a uniquely tailored contract between two parties. The settlement on forward contract takes place on any specified future date but at pre-negotiated price agreed on a present date. 2.2.2. Futures: A futures contract is an accord between two entities either to buy or sell an asset at any given date in the future at a pre agreed rate. Futures contracts can be called as special kind of forward contracts as forwards are standardized instruments which are traded at the exchange market. 2.2.3. Options: These special instruments deal with the rights and associated obligations. Options falls in two categories- call option and put option or simply call and put. Call option give buyer the right but no associated obligation to buy a given underlying asset, at a pre agreed price on or before a given date in future. Whereas Put option give the buyer the right, but no associated obligation to sell a given underlying asset at a pre agreed price on or before a given date in future. 2.2.4. Swaps: Swaps are private contracts between two entities to exchange cash flows at a future date according to a pre agreed terms. The two frequently used swaps are: Interest rate swaps: These involve swapping the interest associated cash flows between the entities dealt in only one currency. Currency swaps: These involve swapping principal as well as interest related cash flows between the entities dealt in two different currencies. 2.3. Risks and the Derivative Derivatives directly or indirectly assist in enhancing the market efficiencies. This is by the fact that risks can be secluded on the basis of intensity and then can be sold to parties which are ready to bear them at the appropriate cost. Derivatives categorise risk into segments which can be dealt one by one independently. Thus it can be said that from a market-oriented outlook a derivative aids free trading of financial risks. 2.3.1. Importance Of Derivatives Various kinds of risks are intrinsic to any financial transactions. Derivatives help in segregating these risks from financial instruments. Then separated risks are sold independently to entities willing to bear these risks. Given below are the fundamental risks associated with derivative business. 2.3.2. Credit Risk: As the name suggests credit risk is the risk associated with collapse of counterparty to fulfil its commitment as per the agreement. It is also named as default or counterparty risk. It differs from instrument to instrument. 2.3.3. Market Risk: Market risk is a financial risk associated with the adverse fluctuations of price of the underlying asset or the instrument itself. 2.3.4. Liquidity Risk: This risk is associated with the inability of a party to manage the cash flow for any transactional obligation at current market prices. 2.3.5. Legal Risk: Derivatives by its nature cut across the boundaries of financial and commercial jurisprudence. Thus there is an inherent legal risk. 3. Determinants of Hedging Various authors like Smith and Stulz (1985), Nance, Smith, and Smithson (1993) and others have analysed the potential determinants of hedging adopted by any organisation. According to these authors, given Modigliani and Miller’s proposition on firm valuation, the remarkable augmentation in usage of derivatives for hedging have following potential determinants. 3.1. Tax Progressivity: A firm which has a convex tax regime (which means that the firm’s income lies in the progressive section of the tax schedule or if the firm has investment tax credits or if the firm has income tax losses), will achieve tax benefits through hedging. 3.2. Financial Distress Costs: The probable direct or indirect costs of bankruptcy increases with the increased likelihood of financial distress. Hence more is the possibility that any firm will hedge against likely bankruptcy through derivatives. Especially smaller firms are more prone to use derivatives reason being their income is volatile in nature which in turn increases the potential for financial distress. 3.3. Agency Costs: Any firm where managers possess a considerable fraction will be more prone towards hedging. It is logical from the view point that the value of wealth owned by managers is directly and proportionally linked with the value of the firm. In a nutshell it can be inferred that higher is the self-interest of a manager in the firm, the more enticing it becomes for a managers to hedge the firm’s cash flows. 3.4. Prevalent Alternatives: It seems very rationale for any firm to use hedging if there is shortage of any such hedging alternative. Alternative could be either financial instruments or business process itself. 3.5. Acquiring Costs: The cost of hedging manipulation directly affects its frequency and extent of use by firms. 3.6. Competitive Rivalry: More competitive the market in which a firm plays, the more it is prone to use hedging instruments. 3.7. Capital Intensiveness: A capital intensive firm is more prone to hedging than a labour intensive firm. 3.8. Market Regulation: A regulated market has less number of players which take resort to hedging as compared to a liberated market. 3.9. Derivatives market Operator a) Hedgers – Those operators who wish to shift one of the risk components of their portfolio. b) Speculators – Those operators who take the risk from hedgers knowingly, in a quest of making profit. c) Arbitrageurs – Those operators who simultaneously operate in the diverse markets, in hope to discard mispricing and to make profit. 4. Firm Value, Risk And Hedging: Literature Review And Ambiguities Despite the fact that the basic purpose of hedging is to cut down on earnings instability, corporate hedging might also enhance the value of the firm. It has been established from public accessible data that hedging decreases the agency costs of debt, lessens to some extent, the agency costs of equity and diminishes the chances financial distress. In spite of this, many studies do not follow the hypothesis that hedging enhances value of the firm through reducing the likely tax burden. Moreover a lot of research studies have proposed that even the configuration of the corporate ownership can influence the likelihood of hedging. It has been also established that big entities are more prone to hedge. On the same league firms with a considerable fraction of value stemming from developmental prospect are more likely to hedge. Allayannis and Weston (2001) have clearly established the fact which has been quite in tandem with the theories, that there exits hedge premium. The study proves its hypothesis that decision to hedge increases value. Smith and Stulz (1985) and Nance, et. al. (1993) proposed that hedging brings down the likely costs of financial distress. Considering that an entity uses derivatives to hedge its liquidity risk and operational risk, hedging should bring down the possibility that the entity will be subjected to financial hitches. Hence, in turn, it will lead to a lower unpredictability of the entity’s value, and reduced likely costs of financial difficulties built in the stock prices. To appreciate these three variables can be taken resort for the probability of financial distress. The first one is the ratio of EBIT to Interest expense. Second one is the value of the firm itself. The last one is the ration of debt to firm value. Any organisation with more debt burden is likely to hedge more. Reason being that the firm will need to restore confidence in its outside investors. It would like to indicate that it is less likely of financial unrest or the possibility of financial default is meagre. In this way the hedgers are likely to have a lower ration of EBIT to interest expense. Similarly they will also try to have a higher ration of debt to firm value. Bali, Hume and Martell (2006) conducted a study to assess if there exits any correlation between a firm’s risk exposures and the level of derivatives used. The study revealed a very surprising result of meagre correlation. It is more surprising in the light of the quantum of derivative transactions and availability of alternatives. The reason behind this could be economic insignificance of the derivative use as compared to organisation’s real operations. Hentschel and Kothari (2001) also came up with almost similar results. The study in its endeavour to gauge the effect of derivatives on the firm's risk characteristics found hardly any difference between hedged and non hedged firms. It seems logical from the stand point that variation in interest rates or exchange rates are not directly linked to organisation's derivative positions. On the other front organisational size also influence its hedging assessment in two paradoxical ways. It can be inferred from work of Warner (1977) that smaller entities have higher likely costs associated with that of financial unrest. In the same league such smaller organisations are in turn more prone to hedging. On the contrary, bigger organisations are well equipped in order to resort to professional risk management specialists. Thus such bigger firms accomplish economies of scale both in terms of informational efficiencies and lower hedging costs. As it has already been discussed above, bigger organisations have the financial muscle to under take especially tailored risk mitigation and management tools, for an example, options and futures to suit the risks faced by them. Relatively bigger organisation will draw out more paybacks from hedging. Hence they are more prone to hedging. It has been debated in many studies that the hedging assessment is linked with economies of scale and in turn with size of the firm. But the size comes initially as a decision variable. Later on, once an entity has already decided to hedge, the quantum of hedging will depend heavily on the expected costs of financial unrest, to which the firm is subjected to. It can be warrantedly inferred from the work of Myers (1977) which highlights the “underinvestment problem”. This means that more the benefits from investments accumulate to the holders of equity or bond more are they likely to do without projects with positive NPV (Net Present Value). Author symbolises equity and bond holder that in order to avoid such condition, entities must use explicit bond covenants as hedging deeds to restore confidence in them that the entity will make sure to bring down the inducement to under invest. Hence organisations with plethora of developmental prospect and a higher debt burden will be more prone to hedging. It can also be concluded that leverage increases the chances of hedging in two ways. In a way it not only enhances the likely costs of financial unrest but also in the other way increases the inducement for underinvestment. As a matter of fact, the former one influences the quantum of hedging whereas the later one latter impacts the hedging decision itself. Moreover, Haushalter (2000) studied the effects of the availability of external financing on hedging decisions. Author suggested that availability of external financing to any organisation make it less prone to hedge. The aspect of agency cost, which comes into picture, when management of any organisation has differently aligned objectives vis-a-vis the shareholders of that firm, also need to be discussed here. Many studies have revealed the fact that over the last few years, the use of ESOP (Employee stock options program) has been in trend as a mode of incentive. This is particularly more valid in the market conditions of the last few years, in which information technology and service organisations enjoy relatively higher stock prices but arbitrarily account for low current earnings. Such entities always need to entice, catch the attention of and retain their highly qualified employees by resorting to unconventional compensation instruments which should consider their prospect of future earning or in other words the stock options. But this is a catch 22 situation of such companies. This situation creates a dilemma for these entities that the value of employee’s stock options is inherently more valuable when the firm’s stock price becomes more unpredictable. Reason being the higher standard deviation or sigma, which is in accordance with the Black-Scholes famous firm valuation formula. Given below is the Black-Scholes model. Table 1: Black-Scholes model In such cases, the managers or the employees are then more averse to hedge the risk subjected to the organisation. As a matter of fact it may be speculated that this view is sternly distorted on the basis of following premises. The employees have to mandatorily hold their stock options for a pre specified period of time which is called as vesting period, before they can be exercised. The employees can end up in loosing their jobs if they are found to be endangering the organisational opulence by not appropriately administering risks. On the contrary, when an employee owns organisations’ stocks entirely, their destiny or hardship is closely linked with the organisational value. If such employees cannot put their eggs in different baskets on their own, then they naturally have more inducement in hedging the firm’s risks in order to mitigate the unpredictability of their own assortment of stocks. Hence, ceteris paribus, the conventional outlook is to look ahead to organisations with a considerable fraction of managerial possession and marginal options held by the entity itself which arbitrarily may not be true as discussed above, to hedge more. Moreover the firms with considerable fraction of external stock holding will be less prone of hedging. Reason being, these external investors can hedge the associated risks in their individual portfolios separately, better than the organisation can (Modigliani and Miller, 1958). Besides using derivatives in whatever form, entities can also use other internal risk management instruments in order to mitigate the risk of financial unrest. As a matter of fact an organisation can take resort to preferential shares instead of debt in order to reduce its possibility of default. Other way round the firm can also increase its liquidity (which is symbolised by its current ratio and the quantum of cash reserves it has as compared to the market value of the firm) by holding a lot of current assets e.g. cash in hand and easily marketable savings. On the same league, any entity with lower dividend payout ratio will have higher residual cash flows on hand for putting into projects with positive NPV for making payments to its debt holders. Hence, any non-hedging organisation will have higher quantum of preferential shares as compared to their assets. They will be more liquid, and at the same time they will have lower dividend payout ratios. 5. Conclusion This assignment has taken a logical stand on the fundamentals and the rational behind the use of derivatives as hedging instruments by the organisations. It is evident from the literature review that there are conflicting and contradicting studies and their outcome lacks in any unanimous accepted standpoint on this matter. This makes the picture ambiguous in totality. Though there have been recent studies which reveal that firms are more often using derivatives in order to counteract the firm’s market risk exposure. 6. References 1. Allayannis, G., & Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of International Money and Finance, 20, 273–296 2. Bali, T.G., Hume, S.R., Martell, T.F. (2007). Does hedging with derivatives reduce the market risk exposure? Journal of Futures Markets, 27, 1053–1083 3. Hentschel, L., & Kothari S.P. (2001). Are corporations reducing or taking risks with derivatives? Journal of Financial and Quantitative Analysis, 36, 93–118 4. Hull, J., 2007. Risk Management and Financial Institutions, 1st Edition, Pearson 5. Nance, D.R., Smith, C.W., & Smithson, C.W. (1993). On the determinants of corporate hedging. Journal of Finance, 48, 267–284 6. Modigliani, Franco, and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, 48, 1958, pp. 261-297 7. Myers, S., “Determinants of Corporate Borrowing,” Journal of Financial Economics, 5(2), 1977, pp. 147-175 8. Stulz, Rene, “Managerial Discretion and Optimal Financing Policies,” Journal of Financial Economics, 26(1), 1990, pp. 3-27 9. Smith, Clifford W., and Rene Stulz, “The Determinants of Firm’s Hedging Policies,”Journal of Financial Quantitative Analyses, 20(4), 1985, pp. 391-405 10. Nance, Deana R., Clifford W. Smith, and Charles W. Smithson, “On the Determinants of Corporate Hedging,” The Journal of Finance, 48(1), 1993, pp. 267-284 11. Tufano, Peter, “Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry,” The Journal of Finance, 51(4), 1996, pp.1097-1137 12. Warner, Jerold, “Bankruptcy Costs, Some Evidence,” The Journal of Finance, 32(2), 1977, pp. 337-348 Read More