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.