Essay on Hedging Student Finance Essay

Hedge funds have grown and deepen their roots in the recent years. At present trillions of dollars of assets are controlled by hedge funds. what happens in the hedge funds market in a matter of concern for every American. In the period of 1998-2008 the amount of hedge funds has increased dramatically. A firm in Chicago said " the funds exploded from $374 billions to almost $2 trillion in a hedge fund research". Flushing with money, hedge funds gained enormous air of mystery and soon became the hottest talk about thing on Wall Street. The financial distress gave rise to the increasing hedging practice. Because the markets have become so uncertain that every investor wants to have a safe net so that he doesn't lose out his money.

Most of the studies carried out in hedge funds are based on two dimensions, the companies who hedge and the companies who don't. Not every company uses derivatives and not every company hedges and there are some who don't prefer disclosing the amount of hedging practice in papers available to the public. Of late empirical evidences have in a way supported the usage of currency borrowings to be a hedge management tool.

What is Hedging?

A hedge is a risk management strategy, an arbitrage situation to minimize the loss from fluctuations in the prices of commodities, currencies or securities. It can be said that hedging is like buying an insurance policy to transfer the risk. Moreover, hedging is like a bet in the gambling sense, where you put another bet in addition to minimize the risk of the unsettled bet. The daily nuance of this practice is to gain a protection against the possible unfavorable outcome. It normally takes into consideration equal and opposite situations in a market, such as cash and future markets as an example. In easier words, you will leave early to catch a train. Here, you are "hedging a bet" to board the train on time. Financial hedges are undertaken to reduce or eliminate the risk of a transaction already taken or an outstanding transaction to be on a safer side.

What are the driving factors of hedging for both financial and non-financial firms?

As we know, all the businesses these days have become international businesses. Hence, the fluctuations in currency are unavoidable. It affects the cash flow, profitability and asset /liabilities positions. All the firms are involved in import and export activities. And the major risk here arises is the currency exchange risk. A company might be earning in Dollars but will be paying for the costs in some other currency. These values change every day. They are highly volatile, escalating and declining dramatically. Hedge is normally related to financial firms like, traders, banks, investment institutions who are exposed to currency risk or speculative businesses. Practically, there is no way any business can be completely immune from the above mentioned risks. And as a risk management practice, the firms make provisions and hire professionals to carry out hedging so as to safeguard their investments. At present, the hedging market is a flippantly regulated group of investment vehicles of similar characteristics. Lately, non-financial firms too have started hedging owing to the fluctuations we just talked about. And in addition there are several benefits as mentioned below:

Tax benefits

Be it a small or a large firm in the countries where the tax structure is just the opposite to the concave tax structure, then these firms can decrease the tax liability by hedging. Smith and Stulz(1985) showed that the volatility is costly for firms with convex effective tax functions. Like in Canada, they have a statutory progressive tax structure for individuals and to limited corporate firms. Let's take an example, if a firm is expecting a loss of $200000 or earn $200000 and tax rate being 30%. Thus, the firm will have to pay $30000 as taxes even though the expected income is zero, without hedging. Here, we have ignored the tax code like the ability to carry forward losses which reduces the tax convexity and provides with a tax incentive to hedge. It has been found in previous studies; the greater the convexity the greater will be the tax benefits. And the tax function is convex when the marginal rate increases. Graham and smith (1999) have said that existing NOLs(net operating loss) provide a disincentive to hedge firms expecting a loss but will offer incentive to hedge for profit expecting firms.

Boosting debt capacity

If we go through the theories of Stulz(1996) , Ross(1947) and Leland(1998) we get to know that by reducing the volatility of income and/or reducing the probability of financial distress, hedging increases debt capacity and which in return also provides to be a tax incentive to hedge. Leland(1998) in his presidential address to American Finance Association had made clear two things as quoted by him " the principal gain comes from the fact that lower leverage volatility allows higher leverage with consequently higher tax benefits" and " a secondary hedging gain comes from lower expected default rates and distress costs, consequential from unused debt capacity". There have been arguments which suggested that tax shield from increased leverage is of more importance than reducing expected distress cost.

Financial distress remedy

Dolde(1995), Berkman & Bradbury(1996), Haushsalter(1998), Gay and Nam(1999), Howton and perfect(1999) and Graham and Rogers(2002) use the debt ratio to measure expected costs of financial distress and found that higher hedging is observed with increasing debt ratios. Volatility will reduce the firm value if the financial distress is sumptuous. Most researches have suggested that the relation between greater expected financial cost give a rise to hedging which presumes that higher debt capacity faces higher financial distress. What hedging/leverage casualty can do is; "hedging may increase debt capacity, but higher leverage can boost up the incentive to hedge". In empirical researches it has been found that the relation between costs of financial distress and hedging are positively correlated with the probability of a firm in financial distress will hedge. Due to the huge cost of bankruptcy, in inevitable for firms to hedge themselves against the huge risks they are exposed to which will lead to a lot of financial distress. Normally these risks are closely relevant to the firms fixed commitments and interest expenses.

Agency problems

When the decision to hedge is contractive, hedging helps in eliminating the agency problem by diminishing both the risk premium and the equilibrium amount of earnings management. Although hedging does not always solve the problem and instead allowing earnings management is preferable but it does help some firms. The main reason behind it being that if they change the structure of earnings management it might lead to inefficiency. So it has both the pros and cons. Although, with an increased hedge option, the principal may achieve efficiency by stringently forbidding the earnings management, since the cost to eliminate dead-weight loss from earnings management can be lowered significantly by hedging.

Restricting shareholder and bondholder interest

Shareholders bear the entire cost of investment and hence would expect the investments to be nurturing but the returns accrue towards the debt holders as well such as shareholders will be worse off. Bessembinder(1999) has once argued that as hedging reduces the profitability in situations of financial distress it proficiently moves individual future states from default to non default results. Hedging firm may promise to obligations in conditions where it wouldn't have been able to negotiate contracts with regards to lower borrowing costs otherwise. Inconsistency in investments will be unfavourable, to an extent of diminishing marginal returns to investment. In current asymmetries the cost of marginal funds will increase with increase in funds. And if they available funds run short, the need will met by borrowing from outside institutions and which will result into decreased investment. This will have a negative impact on the npv and the firm value as a whole. Here, the hedging technique may come out as a good idea to manage the internal funds,provding a safe net on the fluctuations and the firm does not have to spend on borrowing from external sources and thus improve the firm value and the net present value. Thus, a firm with higher level of debts, will undertake a hedging programme, if their growth value is highly affected by the value of the firm.

Improving managers wealth portfolio

If the variability of their compensation is related to the volatility of corporate incomes and cash flows having a convex utility of function then, corporate volatility can be costly (stulz(1984). The Within the hedge fund industry it is the skill of the manager ('alpha'), rather than the performance of a market or asset class ('beta'), that should principally determine how well they perform. As quoted in a publishing by the National Association of Pension Funds Limited 2009. The infamous 2 and 20 formula of compensation has gained a lot of majority and appreciation in hedge funds currently in operation. It means that a hedge fund manager receives 2% of assets and 20% of profits each year out of the hedge fund's operating agreement. In short, if they lose the money, at least a guarantee 2% return with negligible problems will be given. Hence, we can say that a manager earning 1 billion pound may take home 20 million pound by just investing the company's funds in the bank. Its very obvious that with such returns, the client may defect before long and is in the best interest of the fund manager to boost up his returns.

Firms facing currency exchange risk

As almost all the firms these days are engaged in import and exports. There is not just one currency they are dealing with. They might be producing their product in dollars or yen but the remuneration is in different currencies with different exchange rates which fluctuate every day. In such a scenario, its very difficult to maintain the cash flows and the investments and the accounting of the same. Any company wouldn't like to risk their funds and profits to an uncertain market. So they buy forieng currency derivatives and hedge them. So that they don't lose out their profits. It is practically unavoidable for any international firm to not hedge. There are different risks which come as a package with currency exchange risk. The firm is operating in a different currency country, exporting in a different currency, outsourcing the managerial work to another country. The whole world has become a market but the currency is not universal.

The financial firms deal with different currencies. They deal in commercial papers, loans, borrowings, equity, bonds etc. So they are ought to hedge no matter what as a risk management practice. But the firms who in a way have the same need to hedge like these firms also jump into the world of hedge funds. The cost of hedging is no less. But the cost is comparatively less than the risk exposure. Hedging is a necessity of small and medium firms, big companies have a bigger risk appetite. They will be able to raise funds and reinvest and recover their losses which is not the case with small firms.

Hedging has other benefits too like they make the financial statements and more detailed and revealing to the investors and stakeholders which might improve the firm's value in the market.

Any investor would prefer a company who is making provisions for future uncertainties and not just presuming things to go their way when it comes to exchange rate. If a firm is ready to face their risks by taking prior precautions then it can concentrate on its main aim of profit earning and growth. In 1999, Mian studied the annual reports of 3002 companies in 1992 and found that 771 companies did some risk hedging in the course in that year. And out of these 543 firms disclosed their hedging activities in the financial statements and 228 mentioned the use of hedging as a risk management strategy but didn't disclose the details about the extent of hedging. Larger firms were hedging more as compared to smaller firms, because it was relevantly less costlier due to the economies of scale. In 1996, Tufano made several interesting observations: Almost 85% of the industries hedged gold price risk between 1990-1993.

UK firms have a better incentive than the US counterparts ?

US firms basically hedge currency exchange risk and commodity risk more than any other risk. George soros rose to fame and fortune when the British pound was going through a rough phase. Hedge fund managers are now looking for ways to earn out of the financial distress in the European countries. "it is unlikely in Europe, because the way Europe works is incremental crisis, incremental recovery", London-based Robert Marquardt, founder of funds of hedge funds Signet said. The Euro went down to 3.3% percent against the US dollar this year. Brynjolfsson and several other US money managers trying to expect a gain from European crisis say that expect a lot of winners out of Europe's misery. Seeing the rise in the global transactions secondary transactions which was expected reach an aggregated value between 25 euro billion to 30 euro billion, was true. As compared to 20 million euros in 2010 and 25 euros in 2011 it seems Europe will continue to host the bulk of secondary transactions. "The prominent Uk and French markets have continued to fuelled in by the Banks and Insurance companies, whereas public pension funds represent the largest category of sellers in US," says Nicolas Lanel, managin director and head of European secondary market advisory at UBS.

Marleen Groen, CEO and founder of Greenpark Capital, agreed: " Many pension funds are also waiting for further clarity on the implications of the occupational pension funds directive upon their private equity holding." She adds that funds fear renewed recessions in some European countries.

The dominance of the EU in the management of speculative funds is seen to be irresistible. although the dominance will have to be put into a viewpoint: British represent $212 bn - compared with a total of $1000 bn for funds locared in the US - making the London hedge fund market no more than a Trojan horse for the US hedge funds.

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