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Hedging: Refer: Chapter 10,11-Strategic Risk Taking by Aswath Damodaran

Hedging can provide benefits but also has costs. Explicit hedging costs are upfront premiums that reduce current earnings. Implicit costs are more difficult to measure but can limit upside gains. Hedging can reduce volatility, provide protection against extreme events, offer tax benefits, and reduce underinvestment. Larger firms in more financially sophisticated industries tend to hedge more. Common risks hedged are foreign exchange and commodities due to their widespread impact and availability of hedging tools.

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34 views

Hedging: Refer: Chapter 10,11-Strategic Risk Taking by Aswath Damodaran

Hedging can provide benefits but also has costs. Explicit hedging costs are upfront premiums that reduce current earnings. Implicit costs are more difficult to measure but can limit upside gains. Hedging can reduce volatility, provide protection against extreme events, offer tax benefits, and reduce underinvestment. Larger firms in more financially sophisticated industries tend to hedge more. Common risks hedged are foreign exchange and commodities due to their widespread impact and availability of hedging tools.

Uploaded by

Liontini
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Hedging

Refer: Chapter 10,11- Strategic Risk Taking by Aswath Damodaran


To Hedge or Not to Hedge
• Cost of Hedging
• Explicit Cost: The Cost of hedging is easily identifiable and explicitly stated in Profit & Loss
Statement-> Insurance Premium; Buying Options by paying option premium
• It reduces earnings in the period when the hedging tool is purchased; but no further
cash outflow in future. Usually the approach chosen when the risk can bring significant
distress to the firm or when the management has very limited understanding of the
nature of that risk or ability to assess the risk is limited.
• Implicit Cost: Precise cost of hedging difficult to identify. Firms using futures/forwards to
hedge face implicit cost. Usually no upfront expense but the exact outcome of the exercise
will be manifested in future
• Where hedging is done by passing on the cost of the volatility to the trading partner
• In each of the scenario the downside is limited but the firm also has to fore-go significant
upside; the outcome is a range-bound change in earnings/profitability
To Hedge or Not to Hedge: Benefits of Hedging
• Reducing Volatility of Cash flow/Higher Predictability: Possible reduction of Beta leading to lesser cost
of equity/ Higher stability of cash flow across the cycle with possible better credit rating than compared
to peers with similar leverage levels. Lower cost of funds increases firm value for the same cashflow. This
behaviour is subject to behaviour of the industry and sophistication level of the market the company is
located
• Safeguard against catastrophic and extreme event risk: Essential for smaller firms or firms with high
leverage or firms in volatile industries or highly competitive industries
• Tax Benefit: Because risk management smoothens out earnings over a period, in some instances it is
possible that the firm end up paying lesser taxes over a cycle with hedging than without hedging. Typical
benefits accrue to convex tax rate regimes(ie; Tax Rate increases as income increases)
• Tax benefits arise if the cost of hedging is fully tax deductible but the benefits from the same are not fully taxed(say due to
the difference in capital gains tax which is usually lesser than income tax)
• Reduce the underinvestment problem because of risk averse managers and restricted capital markets:
In a real world scenario managers do not ignore risks in investment decision even if those risks are
diversifiable at the hands of the ultimate investors. Hedging cashflows firms are better able to plan
long term investment and exhibit lesser dependence on external sources of funding.
• Firms which hedge, in the course of disclosure of their positions tend to share higher amount of
information to shareholders.
Who Hedges? Which Risks Are Hedged More?
• Firms with scale of operations and ability to invest in trained manpower tend to hedge
more than smaller firms or firms who cannot afford a full team of risk management
professional. Firms in more ‘financially savvy’ industries tend to hedge more. In India
Auto Sector, Pharma, IT and Commodity firms tend to hedge much more than say real
estate/cement/construction firms
• Risks which are ‘on-your face’ , because they affect the earnings on a quarter to quarter
basis are difficult to neglect/ignore. So risks which impact revenue or costs are handled
on a priority basis. Wides spread demand for managing such risks possible, over a period
of time, made easily available tools to hedge, which in turn feeds into the demand for
hedging.
• The most commons risks that are hedged are FX and Commodity; They are Ubiquitous,
affects earnings and are easy to hedge

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