452 Planning and Forecasting
is one in which the firm is hurt if prices move in one direction, but the firm
does not benefit appreciably if the price moves in the other direction. For ex-
ample, a firm that exports to Japan and receives payment in yen benefits when
the value of the yen rises, but is hurt when the yen falls in value. This foreign
exchange risk is thus symmetric. The symmetric foreign exchange risk can be
eliminated most completely with a symmetric instrument such as a future or
for ward, not an option.
A portfolio manager invested in stocks also faces a symmetric risk. He
benefits if stock prices rise, and loses money if stock prices fall. The portfolio
manager, however, might wish to modify the exposure in an asymmetric way,
insuring against losses on the downside while maintaining the potential for
upside appreciation. An asymmetric instrument, a put option, would be the ap-
propriate hedge instrument in this case, since an asymmetric instrument con-
verts a symmetric risk into an asymmetric exposure.
An automobile leasing company is an example of a commercial venture
that faces an asymmetric risk. If interest rates rise, the firm’s interest expenses
rise. If the firm tries to offset these higher costs by charging higher prices to
customers, the firm will lose business. However, if interest rates fall, buying an
automobile on credit becomes a more attractive substitute for leasing unless
the leasing company also lowers its prices. Thus, the leasing company suffers
when rates rise, but does not benefit when rates fall. An asymmetric hedge,
such as a bond put option would be the best choice of instrument in this case.
The bond put option will pay off when rates rise, but will not require a cash
outf low when rates fall.
The key to choosing between symmetric and asymmetric instruments is
to first identify the nature of the risk that is faced, and then choose the type of
instrument which will modify the risk appropriately. A symmetric risk can best
be eliminated with a symmetric instrument. An asymmetric risk can best be
eliminated with an asymmetric instrument. A symmetric risk can be turned
into an asymmetric exposure with an asymmetric instrument.
Finally, the last step is to choose whether the instruments should be of
the exchange-traded or over-the-counter variety. For wards and swaps are over-
the-counter instruments; futures are exchange-traded instruments. Options are
generally exchange-traded, but they can also be bought over the counter.
Exchange-traded instruments are standardized, and are thus liquid and entail
low transaction costs. But since they are standardized, they may not perfectly
suit the risk exposure the firm wishes to hedge. Over-the-counter instruments
can be custom tailored, but they are therefore less liquid and more expensive
in terms of transaction costs. The firm must weigh the costs and benefits of
liquidity, differences in transaction costs, and custom fit. The correct choice
depends on the particular hedging situation.
A couple of examples will illustrate the process of putting all the factors
together to pick the best suited hedge. A U.S. manufacturing firm owns a pro-
duction facility in Canada. Rent and wages are paid in Canadian dollars. Con-
sequently, if the Canadian dollar rises in value, the wages and rent translated