Introduction to Corporate Finance

ONLINE CHAPTER

23 -1b THE HEDGING DECISION

Although it is clear that the corporate demand for hedging and risk-management products has grown

dramatically in recent years, it is less clear why a public company would choose to hedge at all. In

chapters 13 and 15, we learned that, in perfect markets, investors can effectively unwind managers’

decisions regarding capital structure and dividends. Modigliani and Miller^1 showed that managers

could not increase company value by choosing an optimal capital structure or dividend policy. The same

conclusion applies to risk management when markets are perfect. If managers use derivative securities

to hedge a particular risk, investors can trade on their own to undo what managers have done. The

explanation for companies’ hedging activities could be either that markets are imperfect or that managers

hedge for their own benefit rather than for the benefit of shareholders. This section discusses the various

potential motivations for hedging and possible hedging strategies.

Motivations for Hedging

The motivations for buying insurance are similar to those for hedging. However, there are some crucial

differences. By purchasing insurance, a corporation benefits from the insurance company’s expertise, in

terms of its ability to evaluate and price certain types of risks. Therefore, insurance companies have a

comparative advantage in bearing these sources of risk. Similarly, insurance companies have the ability

to process claims more efficiently and effectively than other corporations. For example, insurance

companies have expertise in negotiating, settling and providing legal representation in liability suits.

Hedging market-wide sources of risk, on the other hand, does not seem to provide any real service

other than reduced volatility. In addition, this risk reduction is costly in terms of the resources required

to implement an effective risk-management program. There are direct costs associated with hedging –

transactions costs of buying and selling forwards, futures, options and swaps – and indirect costs in the

form of managers’ time and expertise.

According to modern hedging theory, value-maximising companies hedge because hedging can

increase company value in several ways. The principal reason most companies hedge, however, is

to reduce the likelihood of financial distress. Figure 23.2 illustrates the impact of hedging on the

likelihood of financial distress, showing the range of possible cash flows for the company in a given period

and the associated probability distribution. If the company’s cash flows are below point A on the x-axis,

the company experiences financial distress. By hedging, the company is able to reduce the probability of

the company’s cash flows being below point A.

Reducing the likelihood of financial distress benefits the company by also reducing the likelihood it will

experience the costs associated with this distress. Direct costs of distress include out-of-pocket cash expenses

that must be paid to third parties (such as lawyers, auditors, consultants and court personnel) in the event of

1 Modigliani, F and Miller, MH. ‘The Cost of Capital, Corporate Finance and the Theory of Investment’, American Economic Review, 48, 1958, pp. 261–97.

in the price they pay for cocoa. Hershey could

be faced with having to increase the price of its

products in response to an increase in the price

of cocoa, whereas the price of Nestlé and Mars

products remains the same. Of course, if the price

of cocoa declines, Hershey would benefit from the

lower price, while Nestlé and Mars are committed

to paying a higher price.

example

Keith Woodward, Vice

President of Finance,

General Mills

‘For General

Mills, hedging and

commodities is core to

our business.’

See the entire interview on

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Source: Cengage Learning