Hedging Solution

• Identify the risks
• Distinguish between hedging and speculation
• Evaluate the costs of hedging against the costs of not hedging
• Use the right measuring stick to evaluate hedge performance
• Avoid basing your programme on your market view
• Understand your hedging tools
• Establish a system of controls

• These risks will generally fall into two categories: operating risk and financial risk. For most non-financial organisations, operating risk is the risk associated with manufacturing and marketing activities. In general, operating risks cannot be hedged because they are not traded. 
• The second type of risk - financial risk - is the risk you face due to your exposure to market factors such as interest rates, foreign exchange rates and commodity and shipping prices. Financial risks, for the most part, can be hedged due to the existence of large, efficient markets through which these risks can be transferred. 

• In determining which risks to hedge, you will need to distinguish between the risks the company is paid to take and the ones it is not. Most companies will find they are rewarded for taking risks associated with their primary business activities such as product development, manufacturing and marketing. Most corporations, however, will find they are not rewarded for taking risks which are not central to their basic business (i.e. interest rate, exchange rate, and commodity price risk).

• Another critical factor to consider when determining which risks to hedge is the amount of the potential loss that might occur if the exposure is not hedged. Unless the potential loss is material (i.e. large enough to severely impact your company's earnings) the benefits of hedging may not outweigh the costs, and your business may be better off not hedging.

• One reason corporate risk managers are sometimes reluctant to hedge is because they associate the use of hedging tools with speculation. They believe hedging with derivatives introduces additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks. 
• Financial risks - regardless of whether or not they are managed - exist in every business. The manager who opts not to hedge is betting that the markets will either remain static or move in their favour.

• The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the cost has to be considered in light of the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company stands to suffer if market factors, such as commodity prices or exchange rates, move in an adverse direction. In such cases the cost of hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative to the potential loss. 

• Another reason for not hedging often cited by corporate risk managers is the fear of reporting a loss on a derivative transaction. This fear reflects widespread confusion over the proper benchmark to use in evaluating the performance of a hedge. The key to properly evaluating the performance of all derivative transactions, including hedges, lies in establishing appropriate goals from the start.

• Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices. 

• A final factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options.

• As is true of all other financial activities, a hedging programme requires a system of internal policies, procedures and controls to ensure that it is used properly.
• The system, often documented in a hedging policy, establishes, among other things, the names of the managers who are authorized to enter into hedges; the managers who must approve trades; and the managers who must receive trade confirmations.
• The hedging policy may also define the purposes for which hedges can and cannot be used. For example, it might state that the corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes.
• It may also set limits on the notional value of hedges that may be outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the company's board of directors are aware of the hedging activities used by the corporation's risk managers and that all risks are properly accounted for and managed.

• A well-designed hedging programme reduces both risks and costs.
• Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimising the risks that are not central to the core business.
• Ultimately, hedging increases value by reducing the cost of capital and stabilising earnings.