The first argument for hedging by non financial firms is that there are tax benefits that accrue from hedging. Non-financial firms that hedge against risk receive tax benefits, as compared to non financial firms that do not hedge against risk. There are two sources for these tax benefits. The first one is because of smoothing of earnings that result from effective risk hedging; with hedging of risks, profits will be lower as compared to how they would have been if the firm did not hedge, in times when the risk does not materialize and higher in times when the risk materializes. Hedging results in tax saving over time. Hedging ensures that income is smoothed over time, and there are no periods of exceptionally high income or exceptionally low income. Where the tax is progressive, non –financial firms that the hedge will maintain their income in tax bases with lower tax base as the effect of windfall profit are eliminated. However, when the taxes are proportional, there are no tax benefits that result from hedging. Therefore, using hedging as a risk management tool to smooth out income over time, a firm with volatile income will tend to pay less in taxes over time in a progressive tax regime.
The second argument for hedging by non financial firms is; hedging results in better investment decisions by non-financial firms. In a world with perfect information, managers of a non-financial firm would consider each viable investment based upon its expected cash flows and the level of risk that the investment adds to investors in the non-financial firm. Normally, managers will not be influenced by risks that are diversifiable by investors, however substantial those risks may be, and capital markets are expected to stand ready to supply the funds needed to make these investments. There are frictions that may result in a breakdown of this process. There are two main sources of conflicting interests between shareholders and managers; managerial risk aversion and capital markets frictions. Managers risk aversion results from the fact that a manager may undertake projects with lower risks than what shareholders would consider reasonable because managers seek to protect their employment and not shareholders intend to maximize returns. As a consequence, managers may reject viable value-adding investments projects because the company-specific risk exposure is significant. If the company hedges against risk, managers will invest in viable projects even if they risky because the income volatility has been eliminated.
Capital markets frictions arise when a firm needs to raise equity or debt to finance good viable investment projects if the firm does not have internal funds. Firms that are dependent on issuing new stock issue to finance viable investment projects tend to under invest because they have to issue shares at a discount. Firms have to issue shares at a discount because capital markets do not have perfect information to distinguish between firms raising funds for poor investments and those raising funds for good viable investments easily. This problem worsens as the riskiness of the firm increases. Non-financial firms that hedge against risk will have more stable earnings and are less likely to experience cash flow shortfalls. As a result, firms that hedge will not be dependent on external sources of funds and can stick strategic capital investment plans as they increase their value.
The third argument for hedging by non financial firms is avoidance of financial distress costs. All firms face the like hood of distress under adverse conditions. Although bankruptcy is the final distress cost, there several intermediate costs that are incurred. For instance; customers will be reluctant to purchase the firm’s products, employees will be busy looking for alternative employment and suppliers are likely to impose stricter credit terms. This makes it difficult for firms under distress to recover from distress. It is prudent for non-financial firms to protect themselves from liquidity risks given the high costs associated with distress. Benefits of hedging are only visible if the associated distress costs are large. Generally, smaller non-financial firms incur higher distress costs, and hence they are more likely to hedge. Similarly, firms with higher fixed claims and higher debt ratios are more likely to hedge as compared to firms with lower debt ratios. Firms that experience high income volatility will benefit more from hedging since the possibility of distress are high. Therefore, hedging lowers the likelihood and expected costs associated with financial distress.
Another argument for hedging by non financial firms is the attainment of optimal capital structure and low cost of capital. Non-financial firms that perceive themselves as facing low chances distress and lower expected distress costs are likely to incur more debt. Using debt capital reduces cost of capital because interest on debt creates tax benefits. Interest on debt, unlike dividends paid to shareholders, is an allowable expense for tax purposes. A study that examined 698 publicly traded corporations between the year 1998 and 2003 revealed that there is a strong correlation between hedging against risk and debt capacity of corporations. The study noted that corporations that bought property insurance to hedge against real estate risk, borrowed more funds and had lower costs of capital due to high debt ratios than corporations that did not hedge over the same period. Another study by Klimczak also revealed that there is a strong correlation between hedging against risk and debt capacity of corporations.
The last argument for hedging by non-financial firms is informational benefits that accrue from hedging. Hedging risks that not related to the core business of a corporation makes the financial statement of the corporation to be more informative. This may increase the value of the firm. For example, the financial statement of multinational trading firm that has hedged against currency fluctuation will reflect its operating performance rather than windfall gains and losses that may result from currency fluctuations. Similarly, a hotel management firm that has hedged against exposure to real estate risk can be evaluated by revenues generated from hotel management services rather than capital gains or losses that result from fluctuations in real estate prices. DeMarzo and Duffie (1995) explored evaluated the informational advantages that accrue to investors when corporations hedge against unrelated risks and the impact of hedging behavior of to what extend the hedging behavior is disclosed to investors. They noted that hedging allows investors to evaluate the quality of management by removing irrelevant noise from the process. They also noted that investors assumed that companies with more stable earning have better management compared to companies with volatile earnings. Therefore, non-financial firms that hedge against risk are likely to have a higher value.
Several arguments that have been advanced against hedging by non-financial companies as discussed below. The first one is the costs of hedging. Instruments used in hedging results in implicit and explicit costs to a company. Explicit costs include insurance premiums paid, cost of the option, and brokerage fee on derivatives among others. The larger the risk, the higher the explicit costs will be. Implicit costs on the other hand, opportunity costs of funds locked in financial derivatives, expert fees, legal fees and man-hours lost formulating, selling and managing derivatives. Both implicit and explicit cost of hedging result increased costs of doing business and consequently reduced earning of the firm. Therefore, hedging against risks that may not occur anyway reduces the firm’s earnings and the value of a firm.
The second argument against hedging by non-financial firms arises from the Capital Asset Pricing Model (CAPM). CAPM is a discount rate determination model that concentrates on the movement of different investment with respect to the entire market. The expected return of return obtained using CAPM assumes that all risks that can be eliminated by diversification are done so. Therefore, the resulting expected rate of return only contains an allowance for risks that cannot be eliminated through diversification. The capital asset pricing model gives an expected rate of return that is equal to the risk-free return after adjusting for tax and risk premium of the market. This is based on the assumptions that that investors maximize the utility of end of period wealth, investors are risk averse and that the capital market is perfect and efficient. This theory states that since investors are rational and seek to maximize their returns subject to risks, they will diversify their portfolio and eliminate all risks that are business or industry specific. Therefore, there is no need for firms to hedge against risk because investors will eliminate the risk by diversification anyway. Therefore, well diversified investor portfolio can manage its own risks without firms’ intervention.
Another argument against hedging emanates from the agency theory. Management normally hedge against the risks that benefit them at the expense of shareholders. Managers risk aversion results from the fact that a manager may undertake projects with lower risks than what shareholders would consider reasonable because managers seek to protect their employment and not shareholders intend to maximize returns. Management’s incentive of reducing income variability is occasionally driven by financial accounting reasons. In the same vein, managers may believe that they will be criticized more harshly if they incur foreign exchange losses in their financial statements than for incurring equal or higher costs in avoiding the same foreign exchange losses. Normally, foreign exchanges losses appear in the statement of income as a footnote or as a highly noticeable separate line item, however, the hedging costs of are normally buried in interest or operating expenses.
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