Finance theory does not provide a complete framework for explaining risk management under the fluctuated financial environment in which firm operates. Hence, for corporate managers, they rank risk management as one of their top priorities. One of the strategies to reduce risk is by hedging. This paper will discuss the advantages and disadvantages of hedging risk using financial derivatives.
Hedging depends across various motives. For example, if a manager intends to minimize corporate taxes, he will hedge taxable income. Stulz (1984) and Smith and Stulz (1985) indicate that progressive tax rates and consequently convex tax schedules cause the firm’s expected tax liability to rise with variance of taxable income, indicating that hedging boosts firm value by decreasing the present value of future tax liabilities. If the corporate managers’ main concern to reduce financial distress costs and if the manager can faithfully communicate the company’s probability of default, the manager’s strategy will concentrate on the market value of debt and equity.
Hedging risk has two sides, such as advantage and disadvantage. The main benefit of hedging is to help reduce risk of financial distress that firm might face, and it helps firm to insure themselves from negative event which could lead to financial distress, such as: Inflation, currency rate volatility and interest rates changes. Moreover, it could protect company from distress to the extent where reducing distress cost exceeds the cost of hedging which will increases the value of the firm.
The second advantage would be more money generated by firm who hedge; hedging actually can reduce the firms’ value debt ratio and increases their level of debt capacity (Kale and Noe, 1990). Firm w...
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...sk is also preferable. (Tufano, 1996) stated that most firm hedge against gold price risk in order to smooth out revenues they will receive on output. In addition, there are also firm that use commodity price risk to protect themselves against commodity price in their inputs. In this case, Hershey’s can use futures contracts on cocoa to reduce the cost uncertainty in the future.
In conclusion, hedging risk with financial derivatives can give firm range of benefits such as lower probability of having financial distress, lower value of debt ratio, and earn tax benefit. It can be concluded that firm should hedge risk using financial derivatives because lot evidence shows that firm using this strategy is more successful than those who are not. However, since different type of companies facing different risks, they should not necessarily use the same hedging strategy.
These ratios can be used to determine the most desirable company to grant a loan to between Wendy’s and Bob Evans. Wendy’s has a debt to assets ratio of 34.93% while Bob Evans is 43.68%. When it comes to debt to asset ratios, the company with the lower percentage has the lowest risk. Therefore, Wendy’s is more desirable than Bob Evans. In the area of debt to equity ratios, Wendy’s comes in at 84.31% while Bob Evans comes in at 118.71%. Like debt to assets, a low debt to equity ratio indicates less risk in a company. Again, Wendy’s is the less risky company. Finally, Wendy’s has a times interest earned ratio of 4.86 while Bob Evans owns a 3.78. Unlike the previous two ratios, times interest earned ratio is measured on a scale of 1 to 5. The closer the ratio is to 5, the less risky a company is. From the view of a banker, any ratio over 2.5 is an acceptable risk. Both companies are an acceptable risk, however, Wendy’s is once again more desirable. Based on these findings, Wendy’s is the better choice for banks to loan money to because of the lower level of
DuPont has been known for its low reliance on borrowings. In the 1970’s, the company had to assume a substantial portion of debt of Conoco, a newly acquired company. In 1983, the managers have to decide about the future optimal target debt ratio. Should the company continue to keep about 40% of its assets financed via debt or should it strive to lower its borrowings to 25%?
In assessing Du Pont’s capital structure after the Conoco merger that significantly increased the company’s debt to equity ratio, an analyst must look at all benefits and drawbacks of a high debt ratio. The main reason why Du Pont ended up with a high debt to equity ratio after acquiring Conoco was due to the timing and price at which they bought Conoco. Du Pont ended up buying the firm at its peak, just before coal and oil prices started to fall and at a time when economic recession hurt the chemical industry of Du Pont. The additional response from analysts and Du Pont stockholders also forced Du Pont to think twice about their new expansion. The thought of bringing the debt ratio back to 25% was brought on by the fact that the company saw that high levels of capital spending were vital to the success of the firm and that high debt levels may put them at higher risk for defaulting.
MYERS, S.C. and MAJLUF, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), pp. 187-221.
Our first customer is investor from China who invested large sum of money into KKB’s stocks. He decided to hedge his portfolio and contacted us. We offered him European put option on KKB’s stocks which matures in 9 months with the strike price of $13,1 per GDR. To estimate how much we are to charge for put option, we used data taken from the website of London Stock Exchange (www.londonstockexchange.com), as KKB’s GDR is quoted on this stock exchange. Latest price of the GDR is $16,29 (on 18 April,2008). To calculate volatility we used historical prices of the stock in the interval from 1 January until 18 April, and it is equal to 47,98%. Having all these figures we used Black-Scholes formula and found out the price of put option, which is $0,79. We also checked it on DerivaGem program.
By reducing their risk, UGG’s shareholders are also reducing the variance in their cash flows, thereby making them less financially distressed. This allows them to be able to invest without having to come up with external capital, i.e. loans. Since they are getting new grain elevators, this is a great way for the firm to avoid the costs associated with raising external capital. The less amount of loans UGG has, the less debt that they have, and their debt ratio remains low. This makes them more attractive to better rates when they do have to get loans.
Obviously, financial establishments can endure breathtaking misfortunes notwithstanding when their risk management is top notch. They are, all things considered, in the matter of going out on a limb. At the point when risk management fails, be that as it may, it is in one of the many fundamental ways, almost every one of them exemplified in the present emergency. In some cases, the issue lies with the information or measures that risk directors depend on. At times it identifies with how they recognize and impart the risks an organization is presented to. Financial risk management is difficult to get right in the best of times.
Brealey, Richard A., and Myers, Stewart C. Principles of Corporate Finance. Sixth ed. McGraw Hill, New York, © 2000.
...t the overall WACC. It will change the risk premium expected by equity holders. Less debt equates to a lower risk premium versus greater debt.
According to Guay (1999) firms can reduce dramatically their risk by the means of derivatives. But in the same research he finds out that derivatives could be used either do increase or decrease risk. Guay (1999) undertakes an empirical examination of new derivative users in attempt to find out whether derivatives are used to reduce firm’s risk. The results show that firms use derivatives to hedge, not to speculate by increasing company’s risk. The investigation is conducted for a sample of 254 non-financial corporations starting using derivatives and the outcomes indicate that during this period the companies’ risk has declined with about...
hedging risks and what instruments to use are really depend on whether the company is risk
After the financial crisis of the late 1990s, the demands for risk management tools have increased. The investors have been effectively utilizing such products as KOSPI 200 futures and options, 3-Year KTB futures and USD futures to meet their hedging needs.
...ting in hedging activities in the financial futures market companies are able to reduce the future risk of rising interest rates. By participating in the financial futures market companies are able to trade financial instruments now for a future date (Block & Hirt, 2005).
Cadburys rely on a number of primary sector goods including cocoa beans, sugar cane and milk in the production of their goods.
Financial theories are the building blocks of today's corporate world. "The basic building blocks of finance theory lay the foundation for many modern tools used in areas such asset pricing and investment. Many of these theoretical concepts such as general equilibrium analysis, information economics and theory of contracts are firmly rooted in classical Microeconomics" (Oaktree, 2005)