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return depends on systematic risk. If hedging merely reduces the idiosyncratic risk of the firm’s cash flows, hedging does not change the firm’s value because investors still discount the same cash flows at the same required return
distress costs vs. hedging costs
•Contrary to the strict theoretical arguments, in the real world idiosyncratic risk within a firm can reduce its value.
•For example, suppose that a company experiences a very severe adverse event, then it may face bankruptcy or financial distress. This is an very costly process: lawyers, accountants, “fire-selling” assets,…
•Further, it is also argued that managers of high-risk firms require higher compensation than managers of low risk firms. Reducing the (total) risk of the firm may reduce executive compensation.
•This implies that there might be benefits to hedging at the corporate level
disadvantages of hedging at thecorporate level
•There are some reasons why, if a corporation undertakes risk management, shareholders will view it as an actively bad thing:
1.“Agency problems”. Are you managing risk to provide shareholders with security or yourself with security?
2.Speculation vs. hedging. Are you trying to make money from speculation rather than reducing risk by hedging?
3.Have you got the internal controls and expertise to manage the potential risks that arise from trading derivatives?
operating hedges
•In contrast to transaction exposure, operating exposure is long-term and often difficult to identify accurately. Hence, strategic solutions (as opposed to financial derivatives) are usually appropriate
•The easiest way of doing this is to match your assets and liabilities or natural hedgingmechanism: if revenues and costs in the same currency move in tandem, currency risk is eliminated
•Example: GM is exposed to the fluctuations of the JPY/US$ rate. GM could consider moving part of its factories to Japan to have the same cost structure as Japanese manufacturers
Laker Airways
•Laker Airways founded by Freddie Laker in 1965
•It offered cheap transatlantic flights. Its main client base was the UK. With a British client base, its revenue was largely GBP denominated
•Its cost base –particularly the cost of fuel and the financing of its aircraft –was primarily USD denominated
•When the dollar strengthened in the early 1980s, income no longer covered costs
•It went bankrupt in 1982
Laker Airways
•Here are some options as to how Freddie Laker might have better managed his FX exposure:
•Make sure all costs are in GBP. Aircraft fuel is sold in USD, so it is unlikely that he could have transferred this cost into Sterling. However, in this case, it may have been optimal to make sure all his administrative functions were in the UK. In fact he was probably close to this anyway; little room for improvement here.
•Change his revenue source to make it more overseas based. That is, Laker could have marketed their tickets more aggressively in the United States
Laker Airways
•Changed his financing costs. In the case of Laker this was probably the easiest option. As with most airlines he would have leased his airplanes in USD. It would have been optimal to have changed the terms of his lease agreement to put payments into GBP
further readings
•ESM: Chapter 8, 10
•Allayannis and Weston, 2001, The