Hedging Program Research Articles

Transmisión de precios futuros de maíz del Chicago Board of Trade al mercado spot mexicano

In Mexico, the use of currency hedging program from the Agency Services for Marketing and Agricultural Market Development (ASERCA) is an instrument that has been used by producers of corn (mostly white), for the acquisition of derivatives in the Chicago Board of Trade (CBOT), whose underlying is yellow corn quality US#2. In an environment of high volatility in corn prices, CBOT prices should be adjusted with domestic spot prices to encourage Mexican producers to participate in the program, but through an analysis of multivariate stochastic volatility during the period 2007 to 2012, it showed that the market price of corn futures is not closely related to those recorded prices in some country states, so we can infer that the coverage by ASERCA program does not adequately serves the purpose of protecting domestic farmers growing white corn, although their use has increased.

Financial Hedging and Firm Performance: Evidence from Cross-Border Mergers and Acquisitions

This paper studies the impact of financial hedging on firm performance in cross-border mergers and acquisitions (M&As). Using a sample of 1,369 acquisitions announced by S&P 1500 firms between 2000 and 2014, we find strong evidence that derivatives users experience higher announcement returns than nonusers, which translates into a $193.7 million shareholder gain for an average-sized acquirer. In addition, we find that acquirers with hedging programs have higher deal completion probabilities, longer deal completion time, and better long-term post-deal performance. We confirm our findings after employing an extensive array of models to address the potential endogeneity. Overall, our results provide new insights into a link between corporate financial hedging and firm performance.

Currency Hedging in the Emerging Markets: All Pain, No Gain

Investors in foreign equities are exposed to potential risks from both the movement of security prices and currency exchange rates. Over the past two years, the U.S. dollar has strengthened significantly against most developed and emerging-market currencies, resulting in material performance headwinds for U.S. dollar-based investors. This, in turn, has led to a growing interest in hedging the effects of currency movements on developed international equity holdings. As a consequence, many investors also wonder whether they should apply a similar program to their emerging- market assets. While this is a natural question, it ignores some of the major differences between implementing a hedging program for developed market currencies versus doing so for emerging-market currencies. We discuss these implementation issues and point out the historical relationship between stock price movements and currency returns in emerging markets. The authors find that for many emerging-market countries, these implementation issues make it operationally impossible to hedge many of these currency exposures; for those that are possible to hedge, the current market environment makes it very expensive Furthermore, if one looks at the theoretical impact from hedging currency in emerging markets, it appears to be a minor one over the long term and is equivalent to making episodic market calls in the short term.

Hedge Effectiveness Testing as a Screening Mechanism for Hedge Accounting

Accounting for financial instruments has been subject to much controversy, particularly accounting practices related to derivatives held for hedging purposes. For cash flow hedges, poor matching may result when fair-value accounting is prescribed for the hedging instrument and historical cost is prescribed for the assets that generate the “highly probable forecast transaction” to be hedged. Fair-value accounting may therefore induce excess variations in earnings, which could make a firm appear to be more risky than it actually is. The alternative to fair-value accounting offered by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to firms with hedging programs, hedge accounting, is allowed only if the designated hedge passes a test for prospective hedge effectiveness. We develop a model for the prospective hedge effectiveness of cash flow hedges and find that the “highly effective” criterion of the FASB and IASB fails to recognize the scope of variation of the hedge effectiveness of pure hedges for different types of risk exposures. Prospective hedge effectiveness is not a reliable signal of a speculative component in a derivative portfolio and, consequently, the current “highly effective” screening mechanism cannot effectively separate pure hedges from derivative portfolios that are partly or fully influenced by speculation. We link these and other findings to the current efforts of the FASB and IASB to reform accounting for financial instruments.

Hedging and Firm Value: Measuring the Implications of Airline Hedging Programs

Hedging and Firm Value: Measuring the Implications of Airline Hedging Programs

How Companies Can Use Hedging to Create Shareholder Value

This article provides a framework for designing and evaluating corporate risk management and hedging programs. Corporate risk management has the potential to create substantial shareholder wealth by protecting companies from unexpected events that could force them to put their strategic investment plans on hold or even endanger their existence. However, assessing the performance of risk management, and how it is expected to increase the value of the enterprise, is a difficult undertaking 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 benefits.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 waste of funds or a 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 derivative 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.

The Maturity Structure of Corporate Hedging: The Case of the U.S. Oil and Gas Industry

This paper investigates how firms design the maturity of their hedging programs, and the real effects of maturity choice on firm value and risk. Using a new dataset on hedging activities of 150 U.S. oil and gas producers, we find strong evidence that hedging maturity is influenced by investment programs, market conditions, production specificities, and hedging contract features. We also give empirical evidence of a non-monotonic relationship between hedging maturity and measures of financial distress. We further investigate the motivations of early termination of contracts. Finally, we show that longer hedging maturities could attenuate the impacts of commodity price risk on firm value and risk.

Risk Sharing and Prudence Review for a Regulated Electric Utility: Some Thoughts

To avoid ‘wasted time’ in conducting prudence reviews of utility activities and programs, specific objectives and guidelines need to be defined clearly in a conceptual and operational manner. Considering the significant costs and complexities associated with natural gas hedging programs by electric utilities, appropriate prudence reviews should be conducted on a regular basis.

Optimal Corporate Hedging Using Options with Basis and Production Risk

In this paper we investigate the optimal hedging strategy for a firm using option contracts, where both the role of production (quantity) and basis (proxy) risk are considered. Contrary to the existing literature, we find that the exercise price which minimizes the shortfall of the hedged portfolio is primarily affected by the amount of cash spent on the hedging program. Also, we decompose the effect of quantity and proxy risk showing that the latter greatly affects hedging effectiveness while the former drives the choice of the optimal option contract. Finally, fitting the model parameters to match a financial turmoil scenario confirms that choosing a suboptimal option moneyness leads to a non-negligible economic loss.

Creating Value at the Intersection of Sourcing, Hedging and Trading

Higher commodity prices, along with higher currency and commodity price volatility, have combined with challenging economic circumstances to make for difficult economics within many industries today. These factors can introduce risk to both top‐line revenue and the cost structure, and wreak havoc on net cash flow and profitability. To the extent that high prices and increasing price volatility continue to be the rule in many global commodity categories, the authors suggest that both sourcing and hedging will soon be (if they are not already) near the top of the strategic agenda for many companies.Many companies now design their hedging programs—and in some cases their sourcing—to achieve the goals of reducing cash flow volatility and optimizing value (as opposed to the more conventional aim of minimizing sourced or manufactured unit cost). And a growing number of corporate managements have expressed interest in an even more systematic approach to risk management. Rising pressure for growth and profitability has led companies with large commodities exposures—both those that are naturally long and those with a natural short—to explore a more strategic role for commodity hedging and trading, as well as the use of innovative risk‐shifting mechanisms for inbound and outbound material flows. This article shows how companies can design their commodity risk management programs to make the greatest use of the expertise and capabilities of four different corporate groups: Purchasing, Treasury, Selling, and Marketing.To that end, the authors presents a five‐step program for creating a company‐wide strategic risk management program: The first step involves making active design choices about what risks to “own” and what risks to limit based on the company's strategy, core competencies, and relative competitive advantages in owning that risk. The second step is to establish relevant risk guidelines based on capacity to own risks and, to a lesser extent, risk appetite, with specific hedging targets and benchmarks. This involves defining objectives, priorities, and constraints (for example, protecting liquidity or increasing debt capacity by reducing cash flow volatility). The third step is to identify and characterize a complete inventory of all exposures—source, size and drivers—and those exposures to be managed. This involves defining, measuring and analyzing all exposures (e.g., commodities, FX, interest rates), with special attention to aggregating, netting, natural offsets, and correlations. The fourth step involves comparing the suitability of various hedging tools and determining how to incorporate these tools into a systematic program that will achieve stated goals, views, and risk preferences for each exposure. The fifth and last step is establishing an appropriate risk management operating model, which involves considerations of organizational architecture, management processes, decision rights, information flows, and governance.

Offensive Risk Management: Can Tail Risk Hedging Be Profitable?

Long-horizon investors have traditionally assumed that they do not need to purchase insurance against rare but severe events that can adversely impact their portfolios. Even where insurance is justified, it is interpreted as a “cost” that reduces the potential returns of the portfolio. In our conversations with investment officers, the biggest challenge that they face is the uphill battle convincing investment committees to commit to this cost and potential of relative underperformance to the peer group. But this “defensive” paradigm for purchase of portfolio insurance hides the fact that severe market crises create opportunities for investors who have maintained or have access to liquidity. The purpose of this paper is to illustrate that the opportunity to increase risk exposures in a tail event improves the return distribution of most investment portfolios. We have discussed the concepts behind offensive risk management earlier in Bhansali (2008). The current paper digs deeper into the theory and produces a simple model to support the concepts. More precisely, we show that the “shadow” value of a tail hedging program is positive.

Corporate hedging under a resource rent tax regime

In addition to the ordinary corporate income tax, special purpose taxes are sometimes levied to extract abnormal profits arising from the use of natural resources. Such dual tax regimes exist in Norway for oil and hydropower, where the corresponding special purpose tax bases are unaffected by any derivatives payments. Dual tax firms with hedging programs therefore face the risk of potentially large discrepancies between the tax bases for corporate income tax and special purpose tax. I investigate how this tax base asymmetry influences the extent of hedging of value-maximizing firms facing hedgeable as well as unhedgeable risk. Dual tax firms facing deadweight costs in low-profit events generally demand less hedging than ordinary firms, but otherwise respond similarly to characteristics of the underlying risk exposures. The special purpose tax does not influence firms' hedge portfolios in the absence of deadweight cost.

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers*

In this article, the authors summarize the findings of their recent study of the hedging activities of 92 North American gold mining companies during the period 1989‐1999. The aim of the study was to answer two questions: (1) Did such hedging activities increase corporate cash flows? (2) And if yes, were such increases the result of management's ability to anticipate price movements when adjusting their hedge ratios? Although the author's answer to the first question is “yes,” their answer to the second is “no.”More specifically, the authors concluded that: During the 1989‐1999 period, the gold derivatives market was characterized by a persistent positive risk premium— that is, a positive spread between the forward price and the realized future spot price—that caused short forward positions to generate positive cash flows. The gold mining companies that hedged their future gold production realized an average total cash flow gain of $11 million, or $24 per ounce of gold hedged, per year, as compared to average annual net income of only $3.5 million. Because of the positive risk premium, short derivatives positions did not generate significant losses even during those subperiods of the study when the gold price increased. There was considerable volatility in corporate hedge ratios during the period of the study, which is consistent with managers incorporating market views into their hedging programs and attempting to time the market by hedging selectively. But after attempting to distinguish between derivatives activities designed to hedge and those designed to profit from a view, the authors conclude that corporate efforts to time the market through selective hedging were largely if not completely futile. In fact, the companies' adjustments of hedge ratios appeared to consistently lag instead of leading the market.

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers

The literature on corporate risk management has traditionally assumed that derivative securities are fairly priced, and thus disregarded the possibility that non-financial firms might use derivatives to generate positive returns by exploiting market conditions. This premise has led researchers to rationalize corporate risk management by its beneficial effects on bankruptcy costs and taxes, debt capacity, cost of capital, underinvestment costs, and managerial risk aversion. Our study questions this fundamental premise and thereby makes two principal contributions. First, we show that the assumption that derivatives contracts are fairly priced on average can be violated for an extended period. By studying the hedging activities of a sample of North American gold mining companies over the 1989-1999 period, we find that these firms generated significant excess cash flows by selling gold forward. Our sample firms realized an average total cash flow gain of $11 million or $24 per ounce of gold per year, while their average annual net income was only $3.5 million. The source of these gains is a persistently positive spread between contracted forward prices and realized spot prices. This finding highlights a new motive for the corporate use of derivatives and a new potential source of value associated with risk management that the literature has previously ignored. Second, and in contrast to our first contribution, we show that firms do not realize economically significant cash flow gains by trying to time the market in their use of derivatives. Market-timing in the context of hedging programs is a form of speculation. We find considerable evidence in our sample that managers respond to changing market prices by varying the sizes of their hedge positions, and that this variation is far in excess of what can be explained by changes in a firm's fundamentals. However, these attempts to time the market do not yield positive cash flows on average. We conclude that managers in our study have no market-timing ability and speculating in this way creates no value (and probably destroys value) for shareholders. This finding is in stark contrast to a widely-held view among many corporate executives that market timing should be an integral part of any hedging program.

Southwest Airlines: Hedging and Shareholder Value

This teaching case describes the hedging program of Southwest Airlines and asks students to consider whether the purchase of additional (now more costly) fuel hedging contracts makes sense. The case prepares students to consider arguments for and against hedging. The case also explores the legal implications of hedging and its relationship to shareholder vs. stakeholder theory, and it asks students to consider in what circumstances hedging against unsystematic risk is a proper exercise of fiduciary duty.

Futures for farmers: Hedging participation and the Mexican corn scheme

Administered commodity price schemes in developing countries have proved ineffective in raising farmers' incomes, and price stabilisation through futures markets is increasingly advocated as the alternative policy objective. A potential difficulty is that farmers tend not to hedge extensively, even in developed countries where access to futures markets is long established. Explanations for this reluctance are examined here with context provided by the Mexican hedging programme, which incorporates financial incentives to spur adoption. Applying representative data for corn to a well-known analysis of the hedging decision suggests that limited participation may reflect rational calculation rather than farmer ‘inertia’. A policy implication is that permanent access subsidies are difficult to justify from the national perspective.

Market Crash Risk and Implied Volatility Skewness: Evidence and Implications for Insurer Investments

Insurers in the U.S. hold over $5 trillion in assets, with approximately $1 trillion of these assets held in equities. While insurers manage underwriting risk with reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. We demonstrate, using all options on the S&P 100 from 1996-2002, that 1) the shape of the implied volatility skew has statistically and economically significant forecast power for assessing the degree of market crash risk, 2) implied volatility skew coefficients are significant and consistent with market crash hypotheses, 3) the cost of hedging with put options (crash insurance) varies directly with the probability of market crash, and 4) hedging is least (most) likely to be cost-effective during bull (bear) markets and when the probability of a market crash is below (above) specified threshold levels. Findings are consistent with investor aversion to large losses, and the evidence suggests that a dynamic hedging program dominates continuous hedging for maintaining insurer financial strength.

Futures for Farmers: Hedging Participation and the Mexican Corn Scheme

Administered commodity price schemes in developing countries have proved ineffective in raising farmers' incomes and price stabilisation through futures markets is increasingly advocated as the alternative policy objective. A potential difficulty is that farmers tend not to hedge extensively, even in developed countries where access to futures markets is long established. Explanations for this reticence are examined here with context provided by the Mexican hedging programme, which incorporates financial incentives to spur adoption. Applying representative data for corn to a well-known analysis of the hedging decision suggests that limited participation may reflect rational calculation rather than farmer inertia. A policy implication is that permanent access subsidies are difficult to justify from the national perspective.

Enhancing reinsurance efficiency using index‐based instruments

PurposeDemonstrates the feasibility of, and introduces a practical approach to enhancing, reinsurance efficiency using index‐based instruments.Design/methodology/approachFirst reviews the general mathematical framework of reinsurance optimization. Next, illustrates how index‐based instruments can potentially enhance reinsurance efficiency through a simple yet self‐contained example. The simplicity allows the analytical examination of the cost and benefits of an index‐based contract. Finally, introduces a real‐world model that optimizes index‐based reinsurance instruments using the genetic algorithm.FindingsIdentifies the key factors that determine the efficiency of index‐based reinsurance contracts and demonstrates that, in the property catastrophe reinsurance market, the combined effect of these factors frequently allows the construction of an index‐based hedging program that is more efficient than a traditional excess‐of‐loss reinsurance contract. A robust optimization model based on the genetic algorithm is introduced and shown to be effective in optimizing index‐based reinsurance contracts.Research limitations/implicationsMost financial optimization procedures are subject to parameter risk, which can adversely affect the robustness of their solutions. The reinsurance optimization approach presented in this paper is not completely immune from this problem. It remains a challenging problem for actuarial researchers and practitioners.Practical implicationsThe concept and method proposed in this paper can be applied to designing real‐world reinsurance programs.Originality/valueThis paper makes two contributions to the risk finance literature: a systematic approach for evaluating the costs and benefits of index‐based reinsurance instruments, and an innovative and practical model for optimizing reinsurance efficiency.

Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

Set in June 2001, the case places the student in the role of Scott Topping, Director of Corporate Finance at Southwest Airlines. Scott is responsible for the airline's fuel hedging program. The case describes the importance of jet fuel hedging in the airline industry, the volatility of jet fuel prices, hedging strategies available to manage jet fuel price risk, and related issues. [Note: The time period of the case allows the instructor to discuss additional issues not specifically addressed in the case such as the impact of September 11th, 2001 terror attacks on the airline's hedging strategy and the collapse of Enron (e.g., counterparty credit risk in hedging).] Southwest Airlines has a business model based on being a low cost provider and has been very successful at offering the lowest airfares in the industry. This business strategy has effectively resulted in a consistently increasing market share over the years. A dominant factor on the expense side of its business is the cost of fuel. Fuel is the second largest expense behind labor. Most recently, fuel costs have reached the highest annual average over the six-year period from 1994 to 2000 at $0.7869 per gallon in 2000. This fact has led to the increased importance of minimizing fuel cost for 2001 and beyond. To mitigate the sensitivity to fuel prices, Southwest has consistently hedged its fuel usage but wants to reevaluate the strategies it employs. As listed in the case, the student is asked to evaluate the following hedging strategies: (1) doing nothing, (2) hedge using plain vanilla swaps, (3) hedge using options, (4) hedge using zero cost collars, and (5) hedge using futures contracts. The case is intended for use in an advanced corporate finance course or risk management at the graduate level. However, the case can also be used in an undergraduate risk management course.