How Companies Can Use Hedging to Create Shareholder Value

Abstract

Assessing the performance of a corporate risk management program, and how it is expected to increase the value of the enterprise, is a difficult undertaking mainly because the costs of risk management tend to be much easier to quantify—indeed, they often appear directly on the firm's bottom line—than the expected benefits. This article provides a framework for designing and evaluating corporate risk management and hedging programs.The author begins by discussing how to evaluate the benefits and costs of a risk management program in general terms, and then focuses more directly on the assessment of corporate hedging programs, which are generally conducted with derivatives. In practice, there are many obstacles to designing and carrying out a successful hedging program. But one of the most common has been the tendency of top managements to insist that hedging programs be “costless.” The author argues that just as the purchase of fire insurance is not viewed as a waste of funds or “bad investment” if the insured house does not burn down, the use of derivatives in a well‐designed hedge should not be viewed as a mistake if the deriv ative position produces losses.To guard against this mistake, the people who design and implement risk management strategies must ensure that their CEOs and boards understand the possible outcomes of the strategy—including losses on derivatives position—and how the strategy itself increases the (expected) value of the firm. Further, management should attempt to communicate the principles underlying its risk management program and the value created by its hedging strategy to the investment community.