Why Manage Risk? - Financial Management

Individuals and companies make choices every day about which risks and how much risk they are willing to assume at any point in time. For example, most individuals buy car insurance that has a deductible limit for the various coverage elements, such as collision insurance. Some individuals have a $500 deductible policy, while others may choose a $2,500 deductible policy. This means that the policyholder is responsible for the first $500 or $2,500 of damage to a vehicle in a collision, and the insurance company is responsible only for amounts above the deductible. Why do some individuals choose the $500 limit, others choose $2,500, and still others choose not to carry any collision insurance coverage at all—that is, they self-insure?

Similarly, some firms that sell their products extensively in international export markets or import significant quantities of raw materials and/or finished goods take actions designed to protect themselves from unfavorable currency exchange rate swings. Other firms simply accept this risk as an ordinary risk of doing business. It can be argued, for example, that currency and commodity price volatility is primarily a component of unsystematic risk that investors can effectively eliminate by holding well-diversified portfolios of stocks. If that is the case, why should a company care about this risk?

There are good reasons to seek to eliminate some of these risks by engaging in hedging transactions.When a company hedges a transaction, it assumes offsetting risks that neutralize the original risk. Perhaps the most important reason to hedge a business risk is to reduce the chance of financial distress. Because financial distress is costly and may ultimately lead to the forced liquidation of the firm, it is desirable to reduce the risk of financial distress.

Hence, if a transaction is large enough that potential, but unanticipated, price swings for raw materials could lead the firm to financial distress and/or bankruptcy, it is probably worthwhile for the firm to seek to hedge against this risk. For example, a company that sells diesel fuel under longterm, fixed-price contracts is well-advised to develop hedging strategies to protect against potential increases in oil prices. A collateral benefit of reducing the probability of financial distress through hedging is the fact that firms engaging in effective risk management strategies will normally have an enhanced debt capacity in their capital structure, resulting in a reduced weighted cost of capital.

Another reason why firms engage in hedging transactions to manage their risks is to assure that they will have adequate cash flows to make needed investments. For example, a pharmaceutical company normally has large on-going R&D investment obligations. These investments are the lifeblood of the company. If a firm has extremely volatile cash flow streams because of international currency risk exposure or some other factor, the time may come when there might be a shortfall in the cash needed to sustain these investments. One might argue that the firm could always go to the external capital marketplace to get the necessary funds. Although that is sometimes possible, external capital suppliers may be reluctant to provide funds for intangible asset investments such as R&D at a time when the firm is having difficulty generating operating cash flows.

Finally, it may be advantageous for a firm to hedge some of its largest risks, such as exchange rate risk or future raw material price risk, so that the focus of management’s attention is properly placed on issues under management’s control. Because exchange rate risk and prices of raw materials are largely outside the control of management, it may be desirable to hedge to eliminate these risks, so that management attention can be directed toward day-to-day operating matters that are under their control. A related benefit of hedging these external risks is that it focuses managerial performance appraisal and the determination of incentive compensation on factors that are under management’s control, rather than on things outside of their control.

It is true that many business risks can theoretically be hedged by individual investors and hence do not need to be hedged by the company. However, in practice this is quite difficult for individual investors to do. First, individual investors rarely have enough detailed information about the operational aspects of a company’s performance to allow them to implement effective hedging strategies across the myriad risks faced by a typical company. In addition, there are large economies of scale in implementing hedging strategies, and the company has a huge comparative advantage in hedging because of these economies.

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