Understand role of Hedging & Diversification in limiting the down side & generating profit

JWI 531 Financial Management II, 5/30/13


WK8L1
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Operational success of firms is not merely a function of how well products sell or how well costs are managed - greater forces are at work
eg. currency movement ie Foreign exchange
Global currencies are constantly fluctuating in response to complex macroeconomic forces
Companies that increasingly sell products abroad have to deal with macroeconomic risks associated with international trade.


Think like a risk manager and manage Operational risk in a corporate environment
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(i) Hedge currency risk in multinational businesses
(ii) limit risk associated with key costs and prices

Ask the right questions for your business
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- get practical solutions

Turn Dollars into Sense
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American businesses do $2.5 trillion worth of business outside US borders.
Europe - turbulence
China - yuan steadily risen in value against dollar

Example of complex global forces at work:
Spring 2010    Unilever shares fall 20% unexpectedly (Lipton, Slim-Fast, Dove, Vaseline etc)
        Strong numbers in previous quarter, market stable

        Some Unilever stocks traded in NYSE as American Depositary Receipts (ADRs)
        Shares traded in US$
        Proxies of principal shares listed in UK

        Pound declined 11% vs dollar
        Dollar denominated ADR shares should have falled similarly

        Unilever reports financial results, sets dividend payout in euros
        Euro tumbles vs Pound vs Dollar
        Euro dollar pound Yuan Rupee Real

Hedging Currency Risk
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This is a crucial part of corporate financial success of a business.
Firms Hedge currency exposure through financial derivatives.
Protect against impact of exchange rates.
Purchase cheap insurance against denominations.
Limit the negative effects of an unexpected event.

Currency effects can impact corporate earnings and valuation

Hedging Commodities and Supplies
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Futures contracts: lock in prices with a type of of derivative
steel, oil, metal
without derivatives, they will be forced to deal with volatile price fluctuations.
Derivatives help provide security
When a company sees prices would be rising for crucial inputs such as sugar and cocoa, it takes actions to lock in prices early

Hershey diversified its dependence of cocoa supply
Not cornered
Mitigate risk by locking in predictable prices for crucial inputs, especially those exposed to serious volatility
Avoid exposing earnings to uncertain markets

Southwest Airlines: ingenious hedging strategy
Saw fuel prices rising and locked in oil prices for years => competitive advantage
This made SouthWest Airlines special and stand out => 17 straight years profits, unusual in the industry

Value of a derivative-based hedging: Allows businesses to take future uncertainty and turn it into a fixed, predictable cost.
There is value and risk.

Businesses most exposed to currency fluctuations
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International, Multinationals - Revenues from products or services sold overseas; smaller importers/exporters businesses
European firms - Euro volatility
Global currencies are constantly fluctuating in response to complex macroeconomic forces.
Companies that increasingly sell products abroad have to deal with macroeconomic risks associated with international trade (JWI 531, W8L1)


II. DQ1
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I. What types of businesses are most exposed to currency fluctuations?  
Global currencies are constantly fluctuating in response to complex macroeconomic forces. Companies that increasingly sell products abroad have to deal with macroeconomic risks associated with international trade (JWI 531, W8L1). Companies most at risk would include
(i) Multinational firms that have revenues in multiple currencies
(ii) Importers & Exporters whose cost/profit structure could be dramatically altered by currency fluctuation
(iii) Companies that have not made accurate forecasts and therefore have not successfully hedged against currency fluctuations. Successful firms protect against impact of exchange rates. They purchase cheap insurance against other denominations and limit the negative effects of an unexpected event.
II. What type of businesses are most exposed to fluctuations in the costs of supplies?
Commodities will be the most exposed to supply costs. When profit margins are very thin, any significant change in cost of supplies can be disastrous for the firms. Southwest Airlines hedged against rising fuel supply costs and won big time. But when they made a losing bet, they suffered a brutally tough period, ending their long streak of profitability (JWI 531, W8L1).
Unlike commodities, for firms offering products or services with higher value proposition, the margins are likely to be higher, and therefore they can better absorb variation in supply costs.
Additionally, firms that have not hedged against fluctuations in supply costs will be more exposed.
III. What type of firms are more exposed to fluctuations in the costs of the finished products?
(i) Firms that do not mitigate risk - associated with key costs and prices - by locking in fixed prices of components through derivatives. When a company correctly sees prices would be rising for crucial inputs, it should take actions to lock in prices early.
(ii) Firms that depend on a single source for supply eg. Chocolate firms that did not hedge against cocoa price like Hershey did suffered, forced to buy from a single source that cornered the market.

Hedging through derivatives & diversification can help limit the down side and "buy insurance" for the firm. Hedging can also carry with it high risk that can limit the upside profits for a firm or in the worst case, for those who dabble without understanding the fundamentals, lead a firm to closure or acquisition.

Dr DP