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University of Strathclyde

Department of Accounting and Finance

Treasury Management

Group Assignment

Group members:

Thanh Le-200965398

Gareth Leese-2009976029

Said Abdullaev-200976519

Submitted to: Andrew Marshall

Date of Submission: 30/04/2010

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Table of Contents

Part 1......................................................................................................................3

Part 2......................................................................................................................11

Part 3......................................................................................................................17

Part 4......................................................................................................................19

Part 5......................................................................................................................26

Reference

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Question 1) Lofair Treasury Report

The key function of any treasury department is the safe-guarding and supervision of an

organisation’s financial assets as well as the management of its financial liabilities.

Lofair functions on a low-cost operating model and services a variety of countries

throughout continental Europe in a market where growth is deemed to be “slowing”.

Additionally, Lofair is seeking to increase the number of destinations it services as well as

the number of bases it operates from in order to drive growth. In order to achieve this, the

company plans on investing in 96 new “next generation” aircraft between 2004 and 2009.

It is therefore the role of the treasury department at Lofair to safeguard and supervise the

firm’s financial assets as well as overseeing the management of its financial liabilities, whilst

bearing in mind the strategy of the company. The main concern of the treasury department,

however, is financial risk management.

Key Treasury Functions for Lofair

Cash and Liquidity Management

One of the main and probably one of the most understated treasury functions for Lofair

would entail cash and liquidity management. Indeed without sufficient cash management,

Lofair may find it sufficiently difficult to operate especially in the face of poor liquidity.

Cash and liquidity management is particularly crucial to an airline such as Lofair, which will

most likely have a high proportion of fixed to total costs when compared to other industries.

This leaves the company much more vulnerable to downturns in revenues and must be a

key agenda for the company’s treasury especially in light of the recently agreed investment

program.

Thus in order to ensure Lofair manages its cash efficiently , the Treasury would be required

amongst other duties to forecast as accurately as possible both the timing and the amount

of the cash flows the firm can expect. This will involve liaising closely with management in

order to obtain both relevant and prompt information which could affect cash-flow

forecasts. Additionally, it is the role of the treasury to perform simple cash management

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tasks, such as ensuring cash is collected quickly and that payments made to suppliers be

delayed in order to improve the company’s operating cycle.

Liquidity management is pivotal as it would allow Lofair to take full advantages of

opportunities in the future as well as providing funding for projects (such as the

negotiations with the new airports) and acquisitions (such as the investment in the

aircrafts). As previously mentioned, strong cash and liquidity management will protect Lofir

against a decline in its revenues.

Interest Rate Risk Management

Lofair also has significant exposure to interest rate risk which results from the often

numerous and varied activities of a firm with regards to financing. Changes in the interest

rate can cause variability in the firm’s value and thus, interest rate risk is particularly

concerned with the risk of loss from the uncertainty of future cash flows caused by changes

in the market rate of interest.

As Lofair is planning the purchase of 96 new aircraft between 2004 and 2009, at a total cost

of US$50.5 million each, slight changes in the market rate of interest. Below is Lofair’s

delivery and payment schedule for the purchase of the new aircraft.

Action Cash Outflow Total

Mid-2003 Sign Agreement $48m

1st Installment of 1st 16

planes $120m

2nd Installment of 1st 16

planes $120m $408m

1st Installment of 2nd 16

planes $120m

Mid-2004 RECEIVE 1st set of 16 Planes $560m

2nd Installment of 2nd 16

planes $120m $800m

1st Installment of 3rd 16 $120m

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planes

Mid-2005

RECEIVE 2nd set of 16

Planes $560m

2nd Installment of 3rd 16

planes $120m $800m

1st Installment of 4th 16

planes 120m

Mid-2006 RECEIVE 3rd set of 16 Planes $560m

2nd Installment of 4th 16

planes $120m $800m

1st Installment of 5th 16

planes 120m

Mid-2007 RECEIVE 4th set of 16 Planes $560m

2nd Installment of 5th 16

planes $120m $800m

1st Installment of 6th 16

planes 120m

Mid-2008 RECEIVE 5th set of 16 Planes $560m

2nd Installment of 6th 16

planes $120m $680m

Mid-2009

RECEIVE 6th Set of 16

Planes $560m $560m

$4,848m

Thus, Lofair’s treasury should seek to identify the firm’s current and potential exposure as

well as draw on both internal and external forecasts of interest rates. Another key function

of the treasury in this regard is to ascertain with the management, the future borrowing and

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financing requirements of Lofair and the strategy of the company should be ascertained

such that the treasury can manage the risks using appropriate policies and financial

instruments.

Additionally, the details of the financing should be defined. The company is required to pay

for the aircraft in US dollars and therefore the company may choose to finance its payment

by borrowing either in pounds sterling or US dollars (or indeed the euro). This will affect the

markets in which Lofair’s treasury invokes its interest rate risk management policies. We

make the assumption that the purchase of aircraft is to be financed through debt, as

opposed to a financing lease, which is common in the airline industry. Therefore there it is

also the responsibility to source the best financing for the firm in order to finance

acquisitions and projects.

As previously mentioned, the aim of such policies is to reduce or completely remove if

possible, any uncertainty changes in interest rates may have on Lofair’s future cash flows,

which in turn can reduce the variability of the firm’s value.

Exchange Rate Management

As Lofair is a multi-national business, it is highly likely that the firm is going to be subject to

foreign exchange risk. Indeed, the planned purchase of the 96 new aircraft is denominated

in US dollars which would signal that the treasury would seek to manage Lofair’s exposure

to changes in currency. This is an example of a “transaction exposure”. Transactional

exposures may also be apparent in the costs of purchasing jet fuel, as this is often

denominated in US dollars as well.

Lofair may also need to manage “translation exposure” in relation to foreign exchange. The

company’s assets and revenues are likely to be denominated in both pounds sterling and

euros. This is particularly relevant for Lofair if the company denominates its accounts into

one currency. Translational exposure is more of an accounting issue, rather than a pure cash

flow issue but remains important as it will affect the company’s profit and loss and balance

sheet statements. This remains important as many outsiders such as lenders may place

covenants or restrictions with regards to balance sheet ratios and credit ratings agencies

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may also use this information in order to pass their judgement on the creditworthiness of

the firm, and hence it’s interest costs.

As previously mentioned, Lofair may choose to finance its purchase of the aircraft in a

currency other than the dollar. If debt is denominated in the US dollar, there may be a

potential for loss unless the liabilities are closely matched to assets denominated in the

same currency (in this case the aircraft).

Lofair’s treasury may also seek to steward the groups exposure to “economic risk”. This

arises from the uncertainty associated with future operating cash flows denominated in a

particular currency that may change due to changes in exchange rates. Once again, the

treasury should liaise closely with Lofair’s management in order to determine the best

approach in relation to managing the company’s exposure to foreign exchange risk.

Commodity Risk

As an airline, Lofair is subject to commodity price risk, with particular attention to the price

of jet fuel which is subject to price swings. As this forms a large part of the firm’s expenses

and is vital to the running of the business, it makes sense that the firm’s cost of fuel is

managed to some degree. Thus, the management of fuel and its costs is vital component for

the treasury.

Lofair’s Risk Management Policies

The very nature of Lofair’s business demands a high degree of risk management. As a firm

that possesses high value assets, seemingly financed by debt (as opposed to a financial

lease), with revenues and expenses denominated in several currencies and a reliance on a

commodity subject to price volatility on the world market, the treasury remains a key

component in ensuring Lofair remains stable and competitive in an increasingly saturated

market.

Group policy states that under no circumstances should speculative trading in financial

instruments take place. This is important, as Lofair’s shareholders invest in the company to

provide a travel service, not to speculate on market prices. Therefore, financial instruments

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should only be used to offset the risks posed by assets or liabilities the company already has

or can forecast itself having in the foreseeable future (such as jet fuel use).

The company’s fuel risk management policy seeks to hedge between 70%-90% of the

forecasted rolling annual gallons. Having been adopted to ensure that the future cost of fuel

is locked in, we believe that Lofair currently operates Over the Counter forward contracts on

jet fuel. Forward contracts seek to remove risk in a manner that is equal but opposite to the

underlying position the firm has and provides certainty.

In Lofair’s case, 70%-90% of the forecasted fuel usage is hedged so whilst not fully hedged,

the firm effectively sets a fixed price for the vast majority of the fuel it forecasts itself using.

On closer evaluation, the policy was initially adopted to prevent the group from being

exposed to short-term movements in world jet fuel prices. The company may therefore also

benefit from the use of options on jet fuel. Jet fuel options would serve to protect Lo-fair

from rises in the price of jet fuel whilst allowing the company to benefit if from lower prices

if the price drops sufficiently. This would all come at the cost of a premium but would still

achieve the company’s policy of protecting against price rises whilst allowing the firm to

benefit from sufficient price falls.

With regards to the firm’s foreign currency risk, the group employs an internal hedging

method in managing its sterling exposure. This is performed by the process of “matching

and netting” such that the revenues received in pound sterling are matched to costs

incurred in pound sterling, reducing the firm’s total exposure to market rates of the pound

sterling vis-a-vis the Euro.

Lofair can benefit from this policy as only the net exposure to the pound will need to be

hedged, and this in turn can reduce other charges associated with hedging including dealer

charges and the exchange spread itself. Matching itself, however, is a difficult process that

may not be entirely precise due to the often uncertain nature and timing of cash flows.

The company also uses any unmatched sterling revenue to hedge the exposures Lofair has

to the US dollar. In this case, Lofair is expecting to make payments with regards to the cost

of fuel, maintenance, insurance and of course, the advance deposit payments on its new

aircraft. This leaves the company with transaction exposures to the US dollar and in order to

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cover these exposures, the firm will sell pounds sterling using forward contracts, achieving

certainty. We are also told that any remaining balances are hedged into Euros.

Thus the company seems to deliberately favour using the pound to hedge any currency

exposure it may have to the US dollar. One potential drawback to this is that the company

may be assuming or forecasting that revenues in UK pounds may be sufficient to cover all

the future expenditures that may be required in US dollars.

At present, Lofair serves 15 UK destinations out of a total of 54 destinations and the

majority of its revenues are likely to be denominated in Euros. It therefore, may find it

beneficial to sell forward any unmatched sterling revenues forward into Euro’s before

selling Euro’s forward into US dollars, however this has its own added drawback in

increasing translational risk between Sterling revenues and Euro revenues.

The group has a policy of fixing interest rates for the full term of the forecast borrowing.

The company employs forward interest rate swap agreements. This may imply that the

company also receives favourable interest rates on variable interest loans. By fixing the

interest rate, the company has indicated a minimum level of tolerance towards interest rate

risk. This is a defensive strategy aimed at achieving a certain cost. By doing so, Lofair

protect themselves from unfavourable (rises) movements in the interest rate (as they are

net borrowers) whilst foregoing any benefit that may arise from falls in the interest rate. It

may also be seen as an indication that the company is highly certain of its future borrowings

as it is locking in certain interest costs now.

Conclusion

Lofair has adopted risk management policies which indicate that management is quite

averse to risk, whether this risk is associated with fuel, foreign currency risk or interest rate

risk.

This may be due to the fact that the business is itself, inherently risky. Typically airlines are

regarded to be pro-cyclical, performing well when the economy is performing well, and

struggling during recessions. This can add to the risk profile of the firm, and Lofair’s current

policies possibly reflect that.

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However, in evaluating the policies, we may be able to endorse the use of options as

opposed to over the counter forward contracts as part of the company’s fuel risk

management policy. We are aware that the current policy was adopted with the particular

aim of preventing short-term exposure to adverse movements in the price of jet fuel. Using

options would provide this level of protection but also enable the company to benefit if the

price of jet fuel was also to fall.

Additionally, the company seeks to match its Sterling revenues with its Sterling costs, using

any surplus to sell forward to cover any payments the company may be required to make in

US dollars. This has the benefit of reducing charges and the costs of the spread through the

use of internal hedging. Also this reduces the company’s exposure to “translation costs”

back into the Euro.

Finally, the company currently employs interest rate swaps in order to fix interest rates,

again, signalling a preference for the company’s management over uncertainty. However, as

mentioned previously, airlines tend to have a high proportion of fixed to total costs. Seeing

the company can seemingly achieved a floating rate of interest on better terms, it may serve

the company better in the long-run to allow the interest rate on its debt to float. This would

reduce the fixed costs the company has to pay and it is most likely that the interest rates

would be lower during times of difficulty or recession and higher during periods of strong

economic performance. We accept, however, that this in itself leaves the Lofair open to a

greater degree of uncertainty and makes forecasting future revenues and expenses more

difficult. This in-turn could make managing foreign exchange exposure more difficult.

One thing we would note is that the company is embarking on an expansive rather

aggressive push for growth at a time when the market is slowing and competition is

increasing. It is vitally important that the treasury aligns its policies to match the overall

corporate strategy of the company.

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Question 2:

4S:

Currency on Balance Sheet: GBP

Receives Revenues in: GBP

Payments made in: EUR, CHF and USD

Airfare: USD

Accommodation: EUR, CHF, USD

(i) What risks does the above scenario create for 4S? How would you expect 4S to

hedge these?

4S Plc receives GBP from its customers but it has to pay out in USD, EUR and CHF. 4S Plc

needs to contract to purchase flights and accommodation one year in advance. This

requires 4S Plc to determine the tour prices they will offer customers one year in advance

by using the airfare and accommodation fees at the beginning of the one year period.

4S Plc is exposed to the volatility of USD, EUR and CHF versus GBP. If the overseas

currencies strengthen, 4S’s earning will be eroded if the tour prices remain unchanged

during the financial year.

In currency risks, they normally categorise the risks into three classes including translation

risk, transaction risk and economic risk. If we have to put the 4S’s risks into these

categories, we think 4S Plc is facing the transaction risk and economic risk.

Transaction risk reflects the threat of short term loss when the payment in GBP increase

due to the stronger overseas currencies meanwhile the tour prices are fixed in GBP in

advance.

Economic risk also matter 4S Plc if the sterling continues to be weakened over the long

period. It means in long run if 4S Plc receives sterling revenues but pays out on other

strengthening currency, the 4S Plc will lose its competitive advantage relative to its overseas

competitors.

There are two main windows for 4S to hedge the risks; they are internal and external

hedging methods.

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Internal Hedging Methods:

Leading and Lagging:

It is possible for 4S to negotiate the favoured terms with its suppliers so that 4S can pay

airfares and the accommodation fees early, particularly if 4S forecasts that the GBP is likely

to weaken. By doing this, it will be easier for 4S to determine the tour prices in advance.

Nevertheless, this may be a costly way because 4S probably needs to borrow money from

banks to finance its payment and the company has to bear interest expenses during the

financial year. On the other hand, 4S can also require its customers to pay early or on an

upfront basis so that 4S can fulfil its financial obligation with suppliers earlier.

The leading and lagging method is not really popular in reality. This seems reasonable

because it will be difficult for a company to negotiate a very good payment terms all the

time.

Pricing

There are two ways to deal with pricing problem. Firstly, 4S can offer its suppliers to make

payment in GBP rather than overseas currencies. This will help to hedge the risks but in fact

transfer the currency risk to its suppliers. By doing this, 4S can remove its currency risk.

Another way is to offer floating tour prices. It means the prices will be adjusted up to the

change of currency exchange rate. This is also known as ‘margin protection clauses’.

Although pricing method is more popular than the leading and lagging method (Marshall,

2000), we still think that hedging risk internally can induce a business risk because the

competitors can adopt better business strategies to win the market as the margin of the

industry is very narrow (less than 5% as given)

External hedging methods:

In order to protect itself from the competition of its rival, 4S can consider the use of some

external hedging methods such as using the money market, forwards, futures and options.

For the money market, assuming that 4S has to make twice per year. Every six months, 4S

needs to pay out in EUR, USD and CHF. In order to set up the hedge for each currency, 4S

needs to do following steps:

- Borrow pounds for 6 months

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- Convert pounds into the overseas currency (each currency)

- Invest the amount of money for 6 months

- After 6 months: repay the pound loans (by using revenue), and receiving the

overseas returns on investment in the overseas currencies

For the forward contract, 4S can sign a contract to buy exactly the amount of overseas

currencies to complete its financial obligations in the future.

For the futures contract, 4S might suffer from the weakening pound, in order to hedge this

risk; 4S needs to sell forward contracts in 6 months. If 4S incurs a loss on the spot market,

this will be offset by a gain on the future contract.

It is also possible for 4S to buy option contracts. 4S is of course required to pay out a

premium and they have the right to exercise the option in the event that the overseas

currencies appreciate.

(ii) If the biggest competitor decides not to hedge any of its exposures, what risks does

this create for 4S plc?

There are two main risks affecting 4S plc when its main rival does not hedge its exposure to

currency. The first threat is the cost associating to the pricing strategy (Nain, 2005)1; and

the second threat is the dominance of the rival after earning high profits due to the positive

change in foreign exchange rate (Mello, 2004)2.

For the first risk to 4s would be that its competitor that does not risk manage reduces its

transaction cost by not paying out the hedging cost. In this case it may also be possible for

the rival to offer cheaper tour prices than 4S could otherwise offer. In addition, the tour

prices are more flexible for unhedged companies because they can adjust the tour prices

according to the actual cost (Adam, Nain, 2007). On the other hand, 4S is also exposed to an

‘unhedged’ run in the industry where all smaller competitors follow the risk management

strategy of the big rival. It means 4S may stand alone with its high price tours.

1 http://gates.comm.virginia.edu/uvafinanceseminar/2005%20Amrita%20Nain%20-

%20%20Job%20Market%20Paper.pdf

2 ftp://ftp.cemfi.es/pdf/papers/wshop/mello.pdf

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For the second threat, we agree with the point that in case the competitor decides not to

hedge, it can take benefit from the positive change of the currency exchange rate. It means

that the competitors of 4S can benefit greatly in the event of an appreciating pound. In the

long run, the better earnings may help the rival dominate the hospitality industry though as

previously mentioned, this relies heavily on positive exchange rate movements. Should this

be the case, it will directly threaten the competitive position of 4S in the market. However,

it is crucial to examine whether the hospitality industry is unhedged or hedged one because

in unhedged industry, for example, unhedged companies usually have low profit volatility

and vice versa (Adam, Nain, 2007). For this reason, we temporarily assume that the hedging

is the normal practice in the hospitality industry, and that the main competitor follows the

strategy to achieve a volatile profit. And as mentioned earlier, this will threaten the position

of 4S in long term.

(iii) How would you manage the risk referred to in (ii) above?

When the unhedged company does employ external hedging techniques (as mentioned the

(i)), it needs to use the internal hedging tools. By adopting this strategy it takes advantage of

both positive changes of exchange rate and lower transaction costs. This urges 4S to

consider its risk management policy.

There are different types of risk management policy. They are no cover (like the main

competitor), 100% cover (assumingly like 4S plc), averaging, selective hedging and currency

trading.

From the researches of Adam, Nain and Mello, we think that in order to adopt a strategy to

cope with one of the main competitor 4S needs to consider the following issues: the

volatility of currency rates, the elasticity of demand, and the possibility of herding behaviour

in the hospitality market.

In a low volatile level of currency rates, it is may be less necessary for 4S plc to hedge the

currency. And as assumed in the previous part, we take the hedging to be a given practice in

the hospitality industry. It means the volatility of the currency rate is considerably high. Now

we only need to consider the elasticity of demand and the possibility of herding behaviour

to determine whether it is worth copying the strategy of its competitors or whether 4S can

stand alone with its own strategy.

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We propose a matrix including the possibility of herding behaviour and the elasticity of

demand. We divided both elasticity of demand and the possibility of herding behaviour into

three levels as below:

Possibility of herding

behaviour

High Medium Low

Elasticity

of demand

High (1) (2) (3)

Medium (4) (5) (6)

Low (7) (8) (9)

We try to match the suggested risk management policy and the matrix by seeing the

possible effect on 4S’s earnings.

For (1), if the smaller competitors imitate the big competitors, the prices in the market will

change frequently. At the same time, customers are eager to change their buy decision

upon the price changes, thus, a fixed price policy as 4S Plc supposed to use is not suitable

anymore because the revenue might decrease, and consequently its earnings are eroded. In

this case, we suggest 4S adopts ‘no cover’ policy.

For (2) and (3), the high elasticity of demand will drive 4S into a worse situation when

customers will most likely drift to the competitors in the face of cheaper prices (esp. the

biggest one) because the offering prices of 4S are unchanged over a period. Likewise, even

the elasticity of demand is only medium, but the trend of unhedge spread over the industry;

this can also sweep out partially the market share of 4S. Consequently, the earnings will be

considerably reduced. For this reason, we suggest 4S can use average hedging strategy so

that it can adjust its selling prices.

For the (5) and (6), as the effect on market share of 4S seems to be weaker than the

previous case, we think 4S can use the selective hedging strategy.

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For (7),(8) and (9), as customers are assumed to exhibit a low elasticity of demand for the

products which 4S offers, there is less risk of losing market share to its competitors. The

possible gain for the big competitor is the financial income only. For the financial income, it

is different from company to company, 4S Plc can adopt a speculative strategy or 4S plc can

just fully cover its exposure by focusing on its core business. Thus, for this situation, we

suggest 4S plc follows its own strategy (i.e. hedging policy).

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Question 3:

i. Set up a hedge, draw risk profile, add diagram effect of using option, show

cost of option on diagram

US Revenue US exporter

1.7188 1.750 $/£

Weak £, strong $ Strong £, weak $

Receive: £,

Risk: weaker £, stronger $

Hedging strategy:

Buy a put option on £, September, strike price: 1.750

Contract size: £62,500; Number of contract = £62.5m/£62,500 = 1,000 contracts.

Premium: 0.032

If the rate is greater than 1.750, option lapses.

If the rate is smaller than 1.750, exercise the option.

Breakeven point = 1.750-0.0312 = 1.7188

ii. Explain time value, intrinsic value

Future 1785 PUT

Strike 1750 Mar Jun Sep

Intrinsic value 0 0 0

Time value 68 213 312

iii. Illustrate cash flow if spot rate and future rate are $1.65/£1

Spot = $1.65/£1

Exercise the option

At spot:

$ Return = £ 62.5m * 1.65 = $ 103.125

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At option:

Buy at 1.65

Sell at 1.75

Profit = $0.1/1£

Profit on option

($0.1 - $0.0312)*1000* £62,500 = $4.3m

Total profit in $

= $ 4.3 + $ 103.125 =

Effective rate

$107.425/£62.5 = $1.7188/1£

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Question 4

Introduction

Various definitions exist for corporate hedging, in short hedging is engaging in off-

balance sheet transactions by using forwards, futures, swaps and options and on-balance

sheet transactions in order to reduce the volatility of firm’s value by mitigating uncertainties

that the firm faces. An off-balance sheet foreign currency exposure hedge for a UK

manufacturer facing competition from US could include: selling a forward contract on USD,

selling a currency futures on USD, a swap where by the UK firm receives GBP and pays USD

and buying a put option on USD. An on-balance sheet hedge would be creating production

facilities in the main export country, thus offsetting a devaluation of foreign currency by

changes in production costs or borrowing in foreign currency. Stulz (1996) argues that “the

primary goal of risk management is to eliminate the probability of costly lower-tail outcomes

– those that would cause financial distress or make a company unable to carry out its

investment strategy.” We assume that he meant to say “costly lower left tail outcomes”.

The use of above mentioned derivatives has exploded over several decades with the

recent years witnessing the largest increase (however this is not to say that the volumes are

attributable to hedging only, speculation and financial firms’ activities have also grown) for

example according to CME the US Treasury 10 Bond futures average daily volume stood at

2.5 million contracts in 2006, compare this to just 205,000 in 1990 and according to ISDA the

volume of outstanding notional interest rate and currency swaps went up from $3.45 trillion

in 1990 to $285.7 in 2006 and $403 trillion in 2008.

Hedging vs speculating

Stulz (1996) notes that risk management departments often take a view on interest rates

and currencies and thus try to profit by speculation, in support he cites such disasters as

Metallgesellschaft (although some commentators disagree that the inappropriate hedging

policy was caused by bad decisions, rather by the absence of long term oil futures) and

Daimler-Benz. Some of the determinants of hedging unrelated to Financial Theory were

found by Peter Tufano (1996). He studied gold miners’ exposure to gold prices and showed

that one of the most important determinants of hedging policies was managerial ownership

of shares and the nature of the managerial compensation contracts. Therefore if

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management owns a large proportion of shares then the firm tends to hedge more in order

to reduce the volatility of those holdings and vice-versa. The structure of remuneration

contract is also transferable to other sectors, for example if a company has a small bonus

pool, the management will not get any bonuses unless something changes quickly and

dramatically, this in turn will stimulate more risk taking based on managerial views and

expectations. According to Bartram, Brown, and Fehle (2006) also confirms that a use of a

stock option plan in a corporation can be a determinant of corporate hedging. It can reduce

manager’s risk aversion and decrease the usage of derivatives to manage firm specific risk.

Indeed very often firms that do not openly admit in speculating, actually do so. Faulkender

(2005) demonstrates that interest rate risk management practices are motivated by

speculative rather than hedging considerations. When managers swap between fixed and

floating interest rates, during changes in the yield curves, they often incorporate their own

views on future interest rate movements.

In an efficient market a corporation seeking to make a profit from its views and using

derivatives to that effect means merely raising the risk profile of its assets which does not

add value, since all information is already built in to the price and any investor would be

able to achieve a given set of risk/return characteristic for his portfolio himself. According to

Modigliani-Miler Proposition (1958) “If there are no taxes, no costs of financial distress, no

information asymmetries, no transaction costs and if investors can perform the same

transactions as companies, then the financial policies of the firm are irrelevant”. Hedging is

one of those policies and thus in an efficient market it will not add value since an individual

investor can also use hedging or hold a diversified portfolio to reduce risks. Therefore wide-

spread hedging by corporations can be considered as one of the arguments against market

efficiency. Another issue is diversification, a corporation reducing its diversifiable (non

systemic) risk will add no value to shareholder wealth since shareholders can eliminate

diversifiable risk themselves.

Determinants of Hedging – Early studies

Hedging should be used only when it creates real value and according to finance

literature there are five types of gains: reducing bankruptcy and distress costs, reducing

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future taxes, alleviating conflicts of interest, reducing expected payments to stakeholders

and reducing costs of raising funds. We will now revue them in turn.

When Bankruptcy costs have real costs such as lost customers, legal expenses, the

present value of these costs reduce the value of the firm, thus if hedging can eliminate

these costs it will increase the firm’s value accordingly. Hedging changes the distribution

of firm value so that default is no longer possible.

Hedging can decrease expected taxes, when the firm is on a progressive tax scale and

thus has a convex function of its tax liabilities generated by its earnings.

For many stakeholders such as workers, diversifying the firm’s risk is impossible (no

economies of scale), therefore they would demand a larger wage to compensate for

that. A hedging policy can alleviate this risk for that group of stakeholders.

Decrease conflicts of interest between shareholders and bondholders

A cost of raising funds can be high for a highly levered firm therefore it would have to

forego profitable (positive NPV) projects, through an effective risk management policy

firms can avoid situation of underinvestment.

Many studies have been concerned with the above mentioned determinants in one

way or another. One of the earlier studies was carried out by Nance, Smith Jr. and Smithson

(1993). Using a sample of 169 surveyed firms they tested three hypotheses on the

determinants of hedging. The hypothesis were based on Financial Economics and stated

that firms hedge in order to: increase firm value by reducing expected taxes; reduce the

expected costs of financial distress; reduce other agency costs. The result of their findings

showed that off-balance sheet hedging increased the value of the firm since all the three

above hypothesis hold, however with varying significance. The tax hypothesis suggested

that the benefits of hedging should be greater the higher the probability that the firm’s tax

schedule was in the progressive region, the greater the past tax deductable looses and the

greater the firm’s investment tax credits. Hedging benefits will be greater in reducing

transaction costs of financial distress where there is a greater portion of fixed interest debt

in the firm’s capital structure and the smaller the firm however larger firms are more likely

to hedge. Agency costs imply that the benefit of hedging should be greater the higher the

firm’s gearing and the more growth opportunities exist in its investment set i.e. if a

company is already highly geared and therefore its equity holders have lower residual claim

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on assets, the benefits from a profitable investment will accrue mainly to the bondholders.

They also found that the firm’s financial policies provided a substitute to hedging, for

example the more convertible debt and/or preference shares it had, the more liquid were

the firm’s assets and the smaller the firm’s dividend payout ratio was, the larger was the

substitute for hedging, lower leverage and shorter debt maturities also had the same effect

of reducing hedging. However their results were inconclusive (a significant but very small

coefficient) in supporting the tax and leverage hypotheses.

Changes in financial reporting standards in the early 1990s required firms to disclose

off-balance sheet financial tools used for hedging in the accounts footnotes. This gave an

opportunity to undertake broader study and statistical tests of corporate hedging policies

that were not possible before.

Determinants of Hedging – Later studies

In 1996 Shehzad and Mian published a study that used a sample of 3,022 firms. In it

they acknowledge the results of previous studies including the Nance, Smith and Smithson

(1993) and expand on those. They find that the larger the firm is, the more incidence of

hedging is observed (a relationship cited by many other studies afterwards), thus showing

that economies of scale are present in hedging, something that the previous study failed to

note. In terms of taxes they note that hedgers have lower incidence of progressivity (firm

size also points to this) and even though foreign tax credits (proxy for tax shield) are

significant, evidence related to tax as a whole appears to be very weak. Hedgers do not have

a high market-to-book ratio (a proxy for investment opportunities – “investment

opportunity set”) and this is primarily driven by interest rate hedgers, however this

relationship varies across the type of risks hedged.

In terms of financial policies, hedging was found not to be related to leverage (book

value of debt / (market value of ordinary stock + book value of preferred stock)) as higher

leverage would mean that taping into capital markets would be more expensive, and neither

was it related to liquidity (current ratio). But hedging found to be related to dividend yield

and the dividend payout ratio. Also differences between interest risk and currency risk

hedgers was discovered: Interest risk hedgers have higher leverage and longer debt

maturities while currency hedgers have lower leverage and shorter debt maturities.

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So far in the above mentioned studies we have encountered two somewhat different

results regarding taxes i.e. Nance, Smith and Smithson point out that firms tax more on a

progressive scale, but those are smaller firms which hedge less, and even though the

relationship is positive it is not significant also they find no relationship between leverage

and hedging, while Graham and Rogers (2002) confirm the results of Shehzad and Mian that

taxes are irrelevant in determining hedging policy. They found that there is no relationship

between tax function convexity and hedging. And as also reported by Ammon (1998), this

absence of relationship holds both in UK (unlimited loss carry forward) and USA (20 years

limit on loss carry forward). The second tax related issue they examined related to

increasing debt capacity (interest payments as tax shield) or leverage, here they showed

that by hedging firms can increase debt capacity and as a result – firm value. This benefit is

derived from two sources: firstly lower volatility of earnings allows for greater leverage with

consequently greater tax benefits and secondly “lower expected default rates” and financial

distress costs as a result of unused debt capacity. That is debt capacity grows but only a part

of it is utilised, which results in increasing firm value. Géczy, Minton and Schrand (1997) and

others also find that leverage is one of the most statistically significant variables as a

hedging motivation.

An International Perspective

An International study conducted by Bartram, Brown, and Fehle (2006) examined

7,319 firms in 50 countries (80% of global market capitalisation of nonfinancial companies).

Using a large sample they hoped to resolve some of the conflicting conclusions from the

prior studies.

Their results were consistent with the financial distress and tax hypotheses, where

hedgers have higher leverage and income tax credits and lower liquidity (quick ratios) and

less tangible assets. However, other results were not consistent with the financial distress

hypothesis. In particular the relationship between the size of the company and its hedging

did not hold, also longer debt maturity, and higher interest coverage ratios also failed. Also

the study’s univariate results do not generally support the underinvestment hypothesis

either as hedgers have lower market-to-book ratios (recall that this is our proxy for growth

opportunities, as the market prices in those opportunities the PE ratio also grows) and

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capital expenditures and tend to be less R&D intensive. However, hedgers are more likely to

be growth firms with high debt levels.

Also there was little support for the managerial incentives hypothesis.

On international scale the evidence suggests that market access is likely to be very

important. Hedgers are more often located in countries with larger derivatives markets,

higher GDP per capita, and OECD countries. Other results again reveal mixed evidence for

theoretical predictions. Evidence also suggests that hedgers are likely to be in politically safe

countries as measured by various indices. Hedgers tend to be in countries with better

shareholder rights and less concentrated equity ownership

For FX derivatives, income tax credits and the relationship between market-to-book

and leverage are not very significant. For IR derivatives, profit margin and income tax credits

are not significant.

Problems with samples

It seems that evidence on the main determinants of hedging is not always

conclusive. Guay and Kothari (2003) suggest that firms use derivatives to “fine tune” their

hedging policies which might be predominantly on-balance sheet, thus suggesting that

derivatives create a lot of noise which in turn creates problems for empirical tests related to

underinvestment and financial distress. Another problem relate to measuring the exposure

to derivative contracts, as noted by Judge (2006) some studies focus on the fair value of the

derivative scaled to the firm’s size, this figure is the amount at which the instrument can be

exchanged between the willing parties and is calculated by discounting the future cash flows

to NPV. The fair value of a derivative contract at origination is zero, even though the firm

might be fully hedged. Notional amounts used for measuring hedging, don’t paint an

accurate picture either, as those studies fail to account the risk characteristics of the

contract.

Conclusion

Before the changes in financial reporting standards scholars had to utilise sample

surveys, which caused an obvious problem of non-response, after the early 1990s, as firms

25

started reporting their hedging policies, a lot of data started to become available and

research into hedging really took off. However many scholars still report that much of

potential research areas still exist. In this paper we examined the main determinants of off-

balance sheet hedging to be financial distress, agency problems, financial structure, taxes

and underinvestment in many cases those determinants are connected for example taxes

and financial structure of the firm (leverage). We examined on-balance sheet hedging

alternatives and financial policy alternatives which alleviate the need for hedging. We also

discussed managers’ motivation to hedge or to take on risks by taking views and

speculating.

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Question 5:

i. Describe the forward position one would enter into and determine the C$

value of the payable if you lock in using a forward contract.

Buy a forward contract,

C$ payable = 1.4855 * US$ 1.85m = C$ 2.748175m

ii. Describe the money market hedge for this situation.

9M (based on 365 day

basis)

Deposit Lending

C$ 1.125 1.20206

US$ 0.7397 0.80137

Borrow US$ 1,835,292.516

Convert into C$ at 1.4875 = C$ 2,729,997.618

Invest into money market in 90 days, returns = C$ 2,764,122.588

Repay US$ 1,850,000

Effective rate

C$ 2,764,122.588/US$ 1,850,000 = 1.4941 C$/ 1 US$

iii. Describe the option hedge for this exposure.

Option on C$ - OTC option.

Receive: US$

Risk: weaker US$, stronger C$

Buy option, premium: 2.5% on C$ value at strike price.

Total premium = 2.5% * US$1.85m * (1/0.625) = C$ 0.074m

C$ Canadian exporter

US$/C$

Stronger US$ Stronger C$

Weaker C$ Weaker US$

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iv. Determine the exchange rate, C$/$, at which the option hedge would

produce a better outcome for the firm than the forward hedge and the

exchange rate at which the option would be better than being unhedged.

Option vs. forward

Call X is spot rate which is smaller than strike price 1.6 C$/ 1US$

Return at spot:

US$ 1.85m * X

If X is smaller than 1.6, the profit will be:

1.6 * US$ 1.85m – 2.5%* US$ 1.85m * 1.6 (premium paid at the end of period)

Total profit will be

C$ 1.85m *X + C$2.886 m

Forward contract return is C$ 2.748175m

So, the option is always better than the forward contract.

Hedged vs. Unhedged

The strike price is C$ 1.6/1US$

The premium is 2.5% of face value = 2.5% * US$1.85m* 1.6 = C$ 0.074m

The premium on 1 USD = C$0.074/US$1.85 = C$0.04/US$1

The spot rate at which the hedged position is better than unhedged position is:

X < (1.6 – 0.04) = C$1.56/1US$

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Reference:

Adam T. R., Nain A., (2007), Strategic Risk Management and Product Market Competition

Amrit Judge, 2006, “Why Do Firms Hedge? A Review of the Evidence”, Economics Group

Middlesex University Business School

Deana R. Nance, Clifford W. Smith, Jr., Charles W. Smithson, 1993, “On the Determinants of

Corporate Hedging”, The Journal of Finance, Vol. 48, No. 1 (Mar., 1993), pp. 267-284

Faulkender, M., 2005, “Hedging or market timing? Selecting the interest rate exposure of

corporate debt”, Journal of Finance, Vol. 60, 2005, pp. 931-962

Guay, W. and Kothari, 2003, “How much do firms hedge with derivatives?”, Journal of

Financial Economics, Vol. 70, 2003, pp. 423-461

John R. Graham and Daniel A. Rogers, 2002, “Do Firms Hedge in Response to Tax

Incentives?”, The Journal of Finance, Vol. 57, No. 2 (Apr., 2002), pp. 815-839

Mello A. S., Ruckes. M. E., (2004), Hedging and Product Market Decisions, University of

Wisconsin-Madison

Nain A., (2005), The Strategic Motives for Corporate Risk Management, Job Market Paper

Norbert Ammon, 2006, “Why Hedge? A Critical Review of Theory and Empirical Evidence”

Shehzad L. Mian, 1996, “Evidence on Corporate Hedging Policy”, , The Journal of Financial

and Quantitative Analysis, Vol. 31, No. 3 (Sep., 1996), pp. 419 -439

Stulz, R., 1996, Rethinking risk management, Journal of Applied Corporate Finance 9, 8-24