To hedge or not is the question

B. Venkatesh

MY friend wonders why all companies do not hedge their financial risks.

He considers hedging risk an important aspect of any business. An importer, for instance, runs the risk of the rupee falling against the dollar before the payment is made. The importer could hedge its risk by buying forward dollars.

But not many companies hedge their forex or commodity risks. To clarify my friend's doubt, financial literature does state that hedging risks sometimes do not enhance shareholder value! Here is why.

Investors earn returns for taking on just the systematic risk. This is the risk of the stock moving in line with the broad market. In financial parlance, this relationship is referred to as the stock's beta.

The investor is not compensated for the risk that is unique to the company as she can lower or eliminate such risk by holding a diversified portfolio. So, why then should companies hedge their risk?

Suppose a cement company decides to close down some of its factories due to sharp fall in cement prices. Your equity holdings in that company will fall as the company will earn lower net income due to the plant closure.

But, what if you hold, say, a big housing finance company in your portfolio? Lower cement prices may lead to more demand for residential houses, resulting in more housing loans. In effect, your equity holdings in the housing finance may do well to compensate for the loss suffered in the cement stock. While this example may be simplistic, the message is this: Should a company spend on the hedge if investors can diversify the risk?

This does not mean that companies should not hedge their risks at all. They are most likely to hedge risks if happening of event(s) will lead to bankruptcy.

A small importer may, thus, want to hedge its payments to a US supplier if the likely fall in rupee will threaten its financial health. A bigger company, on the other hand, may choose not to do so. In short, managing risk, like everything else in business, is a pure cost-benefit decision.