Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^812) © The McGraw−Hill
Companies, 2002
is really hedged is the firm’s near-term cash flow. In fact, at the risk of ignoring some
subtleties, we will say that hedging short-term financial exposure, hedging transactions
exposure, and hedging near-term cash flows amount to much the same thing.
It will usually be the case that directly hedging the value of the firm is not really fea-
sible, and, instead, the firm will try to reduce the uncertainty of its near-term cash flows.
If the firm is thereby able to avoid expensive disruptions, then cash flow hedging will
act to hedge the value of the firm, but the linkage is indirect. In such cases, care must be
taken to ensure that the cash flow hedging does have the desired effect.
For example, imagine a vertically integrated firm with an oil-producing division and
a gasoline-retailing division. Both divisions are affected by fluctuations in oil prices.
However, it may well be that the firm as a whole has very little transactions exposure
because any transitory shifts in oil prices simply benefit one division and cost the other.
The overall firm’s risk profile with regard to oil prices is essentially flat. Put another
way, the firm’s net exposure is small. If one division, acting on its own, were to begin
hedging its cash flows, then the firm as a whole would suddenly be exposed to financial
risk. The point is that cash flow hedging should not be done in isolation. Instead, a firm
needs to worry about its net exposure. As a result, any hedging activities should proba-
bly be done on a centralized, or at least cooperative, basis.
Hedging Long-Term Exposure
Price fluctuations can also be longer-run, more permanent changes. These result from
fundamental shifts in the underlying economics of a business. If improvements in agri-
cultural technology come about, for example, then wheat prices will permanently de-
cline (in the absence of agricultural price subsidies!). If a firm is unable to adapt to the
new technology, then it will not be economically viable over the long run.
A firm’s exposure to long-run financial risks is often called its economic exposure.
Because long-term exposure is rooted in fundamental economic forces, it is much more
difficult, if not impossible, to hedge on a permanent basis. For example, is it possible
that a wheat farmer and a food processor could permanently eliminate exposure to
wheat price fluctuations by agreeing on a fixed price forever?
The answer is no, and, in fact, the effect of such an agreement might even be the op-
posite of the one desired. The reason is that if, over the long run, wheat prices were to
change on a permanent basis, one party to this agreement would ultimately be unable to
honor it. Either the buyer would be paying too much, or the seller would be receiving
too little. In either case, the loser would become uncompetitive and fail. Something of
the sort happened in the 1970s when public utilities and other energy consumers entered
into long-run contracts with natural gas producers. Natural gas prices plummeted in later
years, and a great deal of turmoil followed.
Conclusion
In the long run, either a business is economically viable or it will fail. No amount of
hedging can change this simple fact. Nonetheless, by hedging over the near term, a firm
gives itself time to adjust its operations and thereby adapt to new conditions without ex-
pensive disruptions. So, drawing our discussion in this section together, we can say that,
by managing financial risks, the firm can accomplish two important things. The first is
that the firm insulates itself from otherwise troublesome transitory price fluctuations.
The second is that the firm gives itself a little breathing room to adapt to fundamental
changes in market conditions.
786 PART EIGHT Topics in Corporate Finance
economic exposure
Long-term financial risk
arising from permanent
changes in prices or
other economic
fundamentals.