Froot, Scharfstein, and Stein
The purpose of risk management for an organisation is to ensure availability of funds for financing investments. Risk management does not create new wealth; investment does. Wealth-creating investment is only possible if there are funds available to finance it. Risk management must be used to ensure the organisation has enough funds to finance its wealth-creating investments should events arise that threaten the availability of funds.
The best funds to use for funding investments are funds created internally. Funds obtained through debt make the company less attractive for further debt, which may result in a dangerous spiral where it cannot obtain debts when it needs them. Funds raised from equity raise the problem of investors knowing that organisations sell equity when they know it is overpriced. So despite Modigliani and Miller, who posited that how the funds are obtained is generally irrelevant, internally generated cash is best for funding further investments.
Hedging is one way to insulate the organisation from fluctuations of funds availability.
To determine what to hedge, think about events you wish to hedge against, and understand the impact of that event to your cashflow requirements for funding wealth-creating investments. For example, if your company manufactures in Europe (Euro) and sells in the USA. Suppose the Euro appreciates thus making sales in the USA slower. Then cashflow is lessened because a) there is less product demand in the USA and b) the value of dollar sales has decreased comapred to Euro, therefore, there is little incentive to further increase production capacity in Europe, therefore there is lessened need for cashflow during the time. Thus there is little need to hedge.
However, if opposite occurs, and the Euro depreciates, then sales to the US can be expected to increase (cheaper products), however,
Risk management “lets companies borrow from themselves” by shifting funds to when they are more needed.
The goal is to align the internal supply of funds with the demand for funds. The goal is not to insure against the events (such as exchange rate fluctuations) but to ensure the company has the cash it needs during such times.
The company shouldn’t need to worry much about its own stock prices. That is a problem for individual investors. They can mitigate that risk through diversification.
Choices of which financial instrument to use must not be left to financial engineers. Managers must align the instrument to the corporate goal – which is to ensure availability of cash appropriate to the environment it is hedging against.
Two key issues in derivative features is mark-to-market vs over the counter. In the former, you need to top up daily to compensate for short term losses. In the latter you only need to pay at maturity date. The other feature is linearity vs non-linearity. Futures and forward contracts may have no floor. There is symmetry in your gain or loss. Options allows setting a floor to loss, while keeping the option to benefit from the event.
