Chapter 26 Managing Risk 675
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Banks and bondholders recognize these dangers. They try to keep track of the firm’s risks,
and before lending they may require the firm to carry insurance or to implement hedging
programs. Risk management and conservative financing are therefore substitutes, not comple-
ments. Thus a firm might hedge part of its risk in order to operate safely at a higher debt ratio.
Smart financial managers make sure that cash (or ready financing) will be available if
investment opportunities expand. That happy match of cash and investment opportunities
does not necessarily require hedging, however. Let’s contrast two examples.
Cirrus Oil produces from several oil fields and also invests to find and develop new
fields. Should it lock in future revenues from its existing fields by hedging oil prices? Probably
not, because its investment opportunities expand when oil prices rise and contract when they
fall. Locking in oil prices could leave it with too much cash when oil prices fall and too little,
relative to its investment opportunities, when prices rise.
Cumulus Pharmaceuticals sells worldwide and half of its revenues are received in foreign
currencies. Most of its R&D is done in the United States. Should it hedge at least some of its
foreign exchange exposure? Probably yes, because pharmaceutical R&D programs are very
expensive, long-term investments. Cumulus can’t turn its R&D program on or off depending
on a particular year’s earnings, so it may wish to stabilize cash flows by hedging against fluc-
tuations in exchange rates.
Agency Costs May Be Mitigated by Risk Management
In some cases hedging can make it easier to monitor and motivate managers. Suppose your
confectionery division delivers a 60% profit increase in a year when cocoa prices fall by 12%.
Does the division manager deserve a stern lecture or a pat on the back? How much of the
profit increase is due to good management and how much to lower cocoa prices? If the cocoa
prices were hedged, it’s probably good management. If they were not hedged, you will have
to sort things out with hindsight, probably by asking, “What would profits have been if cocoa
prices had been hedged?”
The fluctuations in cocoa prices are outside the manager’s control. But she will surely
worry about cocoa prices if her bottom line and bonus depend on them. Hedging prices ties
her bonus more closely to risks that she can control and allows her to spend worrying time on
these risks.
Hedging external risks that would affect individual managers does not necessarily mean
that the firm ends up hedging. Some large firms allow their operating divisions to hedge away
risks in an internal “market.” The internal market operates with real (external) market prices,
transferring risks from the division to the central treasurer’s office. The treasurer then decides
whether to hedge the firm’s aggregate exposure.
This sort of internal market makes sense for two reasons. First, divisional risks may cancel
out. For example, your refining division may benefit from an increase in heating-oil prices at
the same time that your distribution division suffers. Second, because operating managers do
not trade actual financial contracts, there is no danger that the managers will cause the firm
to take speculative positions. For example, suppose that profits are down late in the year, and
hope for end-year bonuses is fading. Could you be tempted to make up the shortfall with a
quick score in the cocoa futures market? Well . . . not you, of course, but you can probably
think of some acquaintances who would try just one speculative fling.
The dangers of permitting operating managers to make real speculative trades should be
obvious. The manager of your confectionery division is an amateur in the cocoa futures market.
If she were a skilled professional trader, she would probably not be running chocolate factories.^5
(^5) Amateur speculation is doubly dangerous when the manager’s initial trades are losers. At that point the manager is already in deep
trouble and has nothing more to lose by going for broke. “Going for broke” is often called “gambling for redemption.”