Each business or investment strategy in today’s economic environment is exposed to a certain risk. Risk is attributed to a high level of uncertainty about future market trends. This leaves no room for speculation. Business analysts explain that the higher the amount of risk, the higher the expected returns. Investors reap benefits according to their risk. Certain risk management techniques have been developed and improved to suit the volatile and dynamic economic climate in an effort to mitigate the risk. Hedging is a risk management strategy that seeks to insulate the investor from future price fluctuations. Hedging covers an array of items including commodities, currencies, or securities. A hedging strategy consists of offsetting a future position’s probability with the use of certain tools. This includes the put or call option and the future and forward contracts (Bordag & Mikaelyan, 2011).
The main aim of this risk management policy is to reduce the risk that might occur in the future as a result of adverse price movements. An ideal hedge strategy assumes all the risk, and the only costs to be incurred are the price of the hedge. When hedging, it is necessary to understand the risk that the firm experiences. Risk can either be considered as systematic or unsystematic risk. Systematic risk is the risk that faces the whole industry and cannot be eliminated by hedging. On the other hand, unsystematic risk is the risk that is unique to every firm in a given industry. This risk can be reduced or avoided by making use of the various hedging strategies. Hedging also involves protecting or preserving capital against harsh economic eventualities such as high inflation rates. This can be combated by investing in high-yield securities or financial instruments. Examples of such instruments are precious metals, investing in real estate, or bonds notes and shares (Bordag & Mikaelyan, 2011).
Main reasons for hedging
The main reason why corporations and business people hedge is derived from the notion that the central business in which they operate is unpredictable. For many companies, the hedging argument is in favor of the insurance tenets. In this regard, hedging involves taking various insurance policies to mitigate or reduce their exposure to such risk. When a company implements a hedging strategy, the main objective is to reduce its sensitivity to the transactions’ cash flow. Low sensitivity is desired because, during price movements, the transaction value is slightly affected (Lim, & Wang, 2007). A company embraces a hedging strategy to maintain its relevance and competitiveness in the market.
However, hedging strategies are not easy to develop. In this case, every firm is exposed to a unique risk that may not necessarily cut across the industry. The hedging problem is further worsened by the ever-complex economic climate. The competition among companies has significantly improved with the initiative to facilitate a global marketplace. Companies should engage in comprehensive financial management strategies. The main reason is that, if most firms in an industry engage in hedging, those abstaining may incur losses that may affect business.
It is prudent for sophisticated companies to engage in hedging in order to insulate against adverse price movements. However, in implementing a workable hedge management policy, a firm’s experience and personnel will be of considerable influence. Immense pressure from competitors and an aggressive management policy may pave the way for a comprehensive financial and risk management program. Firms with efficient hedging and appropriate financial management skills will be deemed stable. With this stability status, a firm can engage in low funding forms of financing. In this regard, the firm will be spearheading its growth and future progress.
Finally, the risk of a company will be controlled by the company’s shareholders. The shareholders are the owners of the firm. If they are unenthusiastic about risk, the company will automatically invest in risk-free securities such as government securities in order to meet the shareholder demands (Lim & Wang, 2007). The main problem encountered when selecting an ideal hedging strategy is the opportunity cost. This is due to the fact the management needs to seek a balance between the uncertainty and the opportunity cost involved. In the hedging strategy, risk aversion and the risk appetite of the firm’s shareholders have to be considered.
Canadian pulp-and-paper Company hedging strategy
Products from the Canadian pulp-and-paper Company are sold in the U.S. dollar to clients all over the world. Pulp and broadsheets are sold in the United States currency. Therefore, the American dollar is critical in defining the prices. For example, it can be assumed that the Canadian company has engaged in a transaction and expects to receive the US $10 million in a month’s time. However, the company is aware that the existing contract is legally binding and has to be fulfilled or the breach may amount to lawsuits. This is irrespective of the fluctuations in the exchange rate between the Canadian and US dollar. The Canadian company understands that the US dollars are peripheral to their core business. With this notion, the Canadian pulp-and-paper Company will not be ready to indulge in foreign exchange (Kirschner, 2010).
The situation can be deduced from two angles, opportunity and uncertainty
If the Canadian pulp-and-paper company does not implement a hedging strategy, the rate of exchange might be favorable or unfavorable at the same time. In this case, they are unaware of the amount of money that will be received from the $ 10 million. This displays the opportunity cost while the uncertainty is from the fact that future occurrences cannot be predicted with precision (Kirschner, 2010).
Risk is the possibility of an unfavorable eventuality taking place. The Canadian pulp-and-paper Company is faced with price risk. Price risk can be classified into transaction cost, translation cost, and economic risk. Transaction risk will reflect the impact of the fluctuation in the exchange rate on the firm’s cash flow expected in the future. This is the risk that the Canadian pulp-and-paper Company experiences. Translation risk occurs in the case of converting assets from a foreign to the home currency. It is common when dealing with multinational corporations. Economic exposure is experienced when the foreign currency fluctuates and affects the main business of a company (Kirschner, 2010).
The Canadian pulp-and-paper Company has taken a strategy that seeks to insulate against the weakening of the Canadian currency on anything below 1. 5600. This implies that the hedging strategy has a 290,000 Canadian dollar opportunity cost. The Canadian company can utilize various hedging tools. Derivatives, forward contracts, and future contracts are tools that can be used to hedge against foreign exchange fluctuations. These tools are used to enhance the trade between the level of uncertainty and the level of risk involved. All wealth-building practices have advantages and limitations. Therefore, hedging is no exception (Kirschner, 2010).
Benefits of hedging accruing to Canadian pulp-and-paper Company
Hedging strategies are different from company to company. As such, the pitfalls and benefits cannot be similar. The use of the futures contract is an efficient short-term risk minimization strategy for future transactions. The contract also enhanced locking profits and placing the Canadian pulp-and-paper Company in a preferable position (Pigott, 2011). The hedging strategy also makes it possible for market players to survive the harsh economic times by protecting them in the eventuality that there will be a fluctuation in the currency values. In addition to the cash flow protection by locking in profits, hedging facilitates budget forecasts on costs and profits (“Theory Of Probability & Its Applications” 2012).
There are various drawbacks associated with hedging. The cost incurred in hedging may be too high and end up consuming the profits. Risk and return are directly related. It is evident that with the reduction in risk, the returns also experience a decline. Hedging can only be used in case of a lapse in time. In instances of exemplary market performance, hedging reaps minimal benefits. Finally, hedging is a very precise trading strategy. Thus, its application requires skill and expertise (Bebchuk & Fried, 2010).
Financial management has a broad spectrum that covers the hedging strategy. Hedging is the insulation from unsystematic risk. For investors and corporations, financial management is crucial for their survival. However, they should first evaluate the risk involved to develop the best way to combat the risk. Without these crucial tips on financial management, investors might incur avoidable losses.
Bebchuk, L & Fried, J 2010, ‘Paying for Long-Term Performance’, University Of Pennsylvania Law Review, vol. 158, no. 7, pp. 1915-1959.
Bordag, L & Mikaelyan, A 2011, ‘Models of Self-Financing Hedging Strategies in Illiquid Markets: Symmetry Reductions and Exact Solutions’, Letters In Mathematical Physics, vol. 96, no. 1-3, pp. 191-207.
Lim, S & Wang, H 2007, ‘The effect of financial hedging on the incentives for corporate diversification: The role of stakeholder firm-specific investments’, Journal Of Economic Behavior & Organization, vol. 62, no. 4, pp. 640-656.
Kirschner, L 2010, ‘Lost in Translation’, AFP Exchange, vol. 30, no. 3, pp. 54-55.
Theory Of Probability & Its Applications, vol. 43, no. 1, p. 135,
Pigott, I 2011, ‘Hedging can reduce this risk business’, Farmers Weekly, vol. 155, no. 26, p. 34.