Introduction to Corporate Finance

23: Introduction to Financial Risk Management

responses. Nearly all the managers responding to the survey said that avoiding large losses was an

important motivation for their companies’ hedging programs. Other important reasons for hedging cited in

the survey were meeting shareholders’ expectations to hedge, increasing expected cash flows, increasing

company value and reducing the volatility of cash flows. Risk managers did not see reducing the cost

of debt or increasing the amount of debt that their company could borrow as important motivations for

their hedging activities.

Hedging Strategies

In some circumstances, a company may not hedge a risk exposure if it is confident that the risk factor

will be changing in a positive direction, or that it has a comparative advantage in bearing the risk. For

example, if a silver-mining company is convinced that the price of silver will increase in the coming

months, it may choose not to hedge its exposure to changes in the price of silver. When the price of

silver increases, the mining company will benefit from the higher price it will receive for silver. In other

circumstances, a company may over-hedge if it is certain that a risk factor will be changing in a negative

direction. For example, if the mining company is convinced that the price of silver will decrease in the

coming months, it may over-hedge by taking a position in a derivative security that will more than offset

the reduced price it receives for silver, thereby generating a profit on the price decrease. These examples

illustrate that derivatives are an effective means for managers to take a position in a risk factor based

on their expectations. It is important to note that if a company chooses not to hedge a risk exposure, or

chooses to over hedge, it is speculating on changes in the risk factor.

How a company chooses to hedge a given risk exposure will depend on the costs and benefits of the

alternative hedging strategies. The company needs to consider transaction costs, the effectiveness and

accuracy of alternative strategies in offsetting underlying risk exposures, and the liquidity and default

FIGURE 23.3 WHY DO COMPANIES HEDGE?

The figure shows the average response of 1,161 risk managers when asked about the importance of several different
reasons for why the company had a hedging program.

2.64

3.13

3.42

3.55

3.63

3.66

3.69

3 4

1 = Not important

2 = Somewhat important

3 = Important

4 = Very important

1 2

Increase the amount

we can borrow

Reduce cost

of debt

Reduce cash

flow volatility

Increase firm value

Increased expected

cash flows

Shareholders

expect us to

Avoid large losses

Source: Bodnar, Graham, Harvey and Marston, Managing Risk Management: Evidence from a Global Survey of Risk Managers. Unpublished working paper.