University of Strathclyde

Department of Accounting and Finance

Treasury Management

Group Assignment

Group members:

Thanh Le-200965398

Gareth Leese-2009976029

Said Abdullaev-200976519

Submitted to: Andrew Marshall

Date of Submission: 30/04/2010

1
Table of Contents

Part 1......................................................................................................................3

Part 2......................................................................................................................11

Part 3......................................................................................................................17

Part 4......................................................................................................................19

Part 5......................................................................................................................26

Reference

2
Question 1) Lofair Treasury Report

The key function of any treasury department is the safe-guarding and supervision of an
organisation’s financial assets as well as the management of its financial liabilities.

Lofair functions on a low-cost operating model and services a variety of countries

throughout continental Europe in a market where growth is deemed to be “slowing”.
Additionally, Lofair is seeking to increase the number of destinations it services as well as
the number of bases it operates from in order to drive growth. In order to achieve this, the
company plans on investing in 96 new “next generation” aircraft between 2004 and 2009.

It is therefore the role of the treasury department at Lofair to safeguard and supervise the
firm’s financial assets as well as overseeing the management of its financial liabilities, whilst
bearing in mind the strategy of the company. The main concern of the treasury department,
however, is financial risk management.

Key Treasury Functions for Lofair

Cash and Liquidity Management

One of the main and probably one of the most understated treasury functions for Lofair
would entail cash and liquidity management. Indeed without sufficient cash management,
Lofair may find it sufficiently difficult to operate especially in the face of poor liquidity.

Cash and liquidity management is particularly crucial to an airline such as Lofair, which will
most likely have a high proportion of fixed to total costs when compared to other industries.
This leaves the company much more vulnerable to downturns in revenues and must be a
key agenda for the company’s treasury especially in light of the recently agreed investment
program.

Thus in order to ensure Lofair manages its cash efficiently , the Treasury would be required
amongst other duties to forecast as accurately as possible both the timing and the amount
of the cash flows the firm can expect. This will involve liaising closely with management in
order to obtain both relevant and prompt information which could affect cash-flow
forecasts. Additionally, it is the role of the treasury to perform simple cash management

3
tasks, such as ensuring cash is collected quickly and that payments made to suppliers be
delayed in order to improve the company’s operating cycle.

Liquidity management is pivotal as it would allow Lofair to take full advantages of

opportunities in the future as well as providing funding for projects (such as the
negotiations with the new airports) and acquisitions (such as the investment in the
aircrafts). As previously mentioned, strong cash and liquidity management will protect Lofir
against a decline in its revenues.

Interest Rate Risk Management

Lofair also has significant exposure to interest rate risk which results from the often
numerous and varied activities of a firm with regards to financing. Changes in the interest
rate can cause variability in the firm’s value and thus, interest rate risk is particularly
concerned with the risk of loss from the uncertainty of future cash flows caused by changes
in the market rate of interest.

As Lofair is planning the purchase of 96 new aircraft between 2004 and 2009, at a total cost
of US$50.5 million each, slight changes in the market rate of interest. Below is Lofair’s
delivery and payment schedule for the purchase of the new aircraft.

Action Cash Outflow Total

Mid-2003 Sign Agreement $48m
1st Installment of 1st 16
planes $120m
2nd Installment of 1st 16
planes $120m $408m
1st Installment of 2nd 16
planes $120m

Mid-2004 RECEIVE 1st set of 16 Planes $560m

2nd Installment of 2nd 16
planes $120m $800m
1st Installment of 3rd 16 $120m

4
 planes

RECEIVE 2nd set of 16

Mid-2005 Planes $560m
2nd Installment of 3rd 16
planes $120m $800m
1st Installment of 4th 16
planes 120m

Mid-2006 RECEIVE 3rd set of 16 Planes $560m

2nd Installment of 4th 16
planes $120m $800m
1st Installment of 5th 16
planes 120m

Mid-2007 RECEIVE 4th set of 16 Planes $560m

2nd Installment of 5th 16
planes $120m $800m
1st Installment of 6th 16
planes 120m

Mid-2008 RECEIVE 5th set of 16 Planes $560m

2nd Installment of 6th 16
planes $120m $680m

RECEIVE 6th Set of 16

Mid-2009 Planes $560m $560m

$4,848m
Thus, Lofair’s treasury should seek to identify the firm’s current and potential exposure as
well as draw on both internal and external forecasts of interest rates. Another key function
of the treasury in this regard is to ascertain with the management, the future borrowing and

5
financing requirements of Lofair and the strategy of the company should be ascertained
such that the treasury can manage the risks using appropriate policies and financial
instruments.

Additionally, the details of the financing should be defined. The company is required to pay
for the aircraft in US dollars and therefore the company may choose to finance its payment
by borrowing either in pounds sterling or US dollars (or indeed the euro). This will affect the
markets in which Lofair’s treasury invokes its interest rate risk management policies. We
make the assumption that the purchase of aircraft is to be financed through debt, as
opposed to a financing lease, which is common in the airline industry. Therefore there it is
also the responsibility to source the best financing for the firm in order to finance
acquisitions and projects.

As previously mentioned, the aim of such policies is to reduce or completely remove if

possible, any uncertainty changes in interest rates may have on Lofair’s future cash flows,
which in turn can reduce the variability of the firm’s value.

Exchange Rate Management

As Lofair is a multi-national business, it is highly likely that the firm is going to be subject to
foreign exchange risk. Indeed, the planned purchase of the 96 new aircraft is denominated
in US dollars which would signal that the treasury would seek to manage Lofair’s exposure
to changes in currency. This is an example of a “transaction exposure”. Transactional
exposures may also be apparent in the costs of purchasing jet fuel, as this is often
denominated in US dollars as well.

Lofair may also need to manage “translation exposure” in relation to foreign exchange. The
company’s assets and revenues are likely to be denominated in both pounds sterling and
euros. This is particularly relevant for Lofair if the company denominates its accounts into
one currency. Translational exposure is more of an accounting issue, rather than a pure cash
flow issue but remains important as it will affect the company’s profit and loss and balance
sheet statements. This remains important as many outsiders such as lenders may place
covenants or restrictions with regards to balance sheet ratios and credit ratings agencies

6
may also use this information in order to pass their judgement on the creditworthiness of
the firm, and hence it’s interest costs.

As previously mentioned, Lofair may choose to finance its purchase of the aircraft in a
currency other than the dollar. If debt is denominated in the US dollar, there may be a
potential for loss unless the liabilities are closely matched to assets denominated in the
same currency (in this case the aircraft).

Lofair’s treasury may also seek to steward the groups exposure to “economic risk”. This
arises from the uncertainty associated with future operating cash flows denominated in a
particular currency that may change due to changes in exchange rates. Once again, the
treasury should liaise closely with Lofair’s management in order to determine the best
approach in relation to managing the company’s exposure to foreign exchange risk.

Commodity Risk

As an airline, Lofair is subject to commodity price risk, with particular attention to the price
of jet fuel which is subject to price swings. As this forms a large part of the firm’s expenses
and is vital to the running of the business, it makes sense that the firm’s cost of fuel is
managed to some degree. Thus, the management of fuel and its costs is vital component for
the treasury.

Lofair’s Risk Management Policies

The very nature of Lofair’s business demands a high degree of risk management. As a firm
that possesses high value assets, seemingly financed by debt (as opposed to a financial
lease), with revenues and expenses denominated in several currencies and a reliance on a
commodity subject to price volatility on the world market, the treasury remains a key
component in ensuring Lofair remains stable and competitive in an increasingly saturated
market.

Group policy states that under no circumstances should speculative trading in financial
instruments take place. This is important, as Lofair’s shareholders invest in the company to
provide a travel service, not to speculate on market prices. Therefore, financial instruments

7
should only be used to offset the risks posed by assets or liabilities the company already has
or can forecast itself having in the foreseeable future (such as jet fuel use).

The company’s fuel risk management policy seeks to hedge between 70%-90% of the
forecasted rolling annual gallons. Having been adopted to ensure that the future cost of fuel
is locked in, we believe that Lofair currently operates Over the Counter forward contracts on
jet fuel. Forward contracts seek to remove risk in a manner that is equal but opposite to the
underlying position the firm has and provides certainty.

In Lofair’s case, 70%-90% of the forecasted fuel usage is hedged so whilst not fully hedged,
the firm effectively sets a fixed price for the vast majority of the fuel it forecasts itself using.
On closer evaluation, the policy was initially adopted to prevent the group from being
exposed to short-term movements in world jet fuel prices. The company may therefore also
benefit from the use of options on jet fuel. Jet fuel options would serve to protect Lo-fair
from rises in the price of jet fuel whilst allowing the company to benefit if from lower prices
if the price drops sufficiently. This would all come at the cost of a premium but would still
achieve the company’s policy of protecting against price rises whilst allowing the firm to
benefit from sufficient price falls.

With regards to the firm’s foreign currency risk, the group employs an internal hedging
method in managing its sterling exposure. This is performed by the process of “matching
and netting” such that the revenues received in pound sterling are matched to costs
incurred in pound sterling, reducing the firm’s total exposure to market rates of the pound
sterling vis-a-vis the Euro.

Lofair can benefit from this policy as only the net exposure to the pound will need to be
hedged, and this in turn can reduce other charges associated with hedging including dealer
charges and the exchange spread itself. Matching itself, however, is a difficult process that
may not be entirely precise due to the often uncertain nature and timing of cash flows.

The company also uses any unmatched sterling revenue to hedge the exposures Lofair has
to the US dollar. In this case, Lofair is expecting to make payments with regards to the cost
of fuel, maintenance, insurance and of course, the advance deposit payments on its new
aircraft. This leaves the company with transaction exposures to the US dollar and in order to

8
cover these exposures, the firm will sell pounds sterling using forward contracts, achieving
certainty. We are also told that any remaining balances are hedged into Euros.

Thus the company seems to deliberately favour using the pound to hedge any currency
exposure it may have to the US dollar. One potential drawback to this is that the company
may be assuming or forecasting that revenues in UK pounds may be sufficient to cover all
the future expenditures that may be required in US dollars.

At present, Lofair serves 15 UK destinations out of a total of 54 destinations and the

majority of its revenues are likely to be denominated in Euros. It therefore, may find it
beneficial to sell forward any unmatched sterling revenues forward into Euro’s before
selling Euro’s forward into US dollars, however this has its own added drawback in
increasing translational risk between Sterling revenues and Euro revenues.

The group has a policy of fixing interest rates for the full term of the forecast borrowing.
The company employs forward interest rate swap agreements. This may imply that the
company also receives favourable interest rates on variable interest loans. By fixing the
interest rate, the company has indicated a minimum level of tolerance towards interest rate
risk. This is a defensive strategy aimed at achieving a certain cost. By doing so, Lofair
protect themselves from unfavourable (rises) movements in the interest rate (as they are
net borrowers) whilst foregoing any benefit that may arise from falls in the interest rate. It
may also be seen as an indication that the company is highly certain of its future borrowings
as it is locking in certain interest costs now.

Conclusion

Lofair has adopted risk management policies which indicate that management is quite
averse to risk, whether this risk is associated with fuel, foreign currency risk or interest rate
risk.

This may be due to the fact that the business is itself, inherently risky. Typically airlines are
regarded to be pro-cyclical, performing well when the economy is performing well, and
struggling during recessions. This can add to the risk profile of the firm, and Lofair’s current
policies possibly reflect that.

9
However, in evaluating the policies, we may be able to endorse the use of options as
opposed to over the counter forward contracts as part of the company’s fuel risk
management policy. We are aware that the current policy was adopted with the particular
aim of preventing short-term exposure to adverse movements in the price of jet fuel. Using
options would provide this level of protection but also enable the company to benefit if the
price of jet fuel was also to fall.

Additionally, the company seeks to match its Sterling revenues with its Sterling costs, using
any surplus to sell forward to cover any payments the company may be required to make in
US dollars. This has the benefit of reducing charges and the costs of the spread through the
use of internal hedging. Also this reduces the company’s exposure to “translation costs”
back into the Euro.

Finally, the company currently employs interest rate swaps in order to fix interest rates,
again, signalling a preference for the company’s management over uncertainty. However, as
mentioned previously, airlines tend to have a high proportion of fixed to total costs. Seeing
the company can seemingly achieved a floating rate of interest on better terms, it may serve
the company better in the long-run to allow the interest rate on its debt to float. This would
reduce the fixed costs the company has to pay and it is most likely that the interest rates
would be lower during times of difficulty or recession and higher during periods of strong
economic performance. We accept, however, that this in itself leaves the Lofair open to a
greater degree of uncertainty and makes forecasting future revenues and expenses more
difficult. This in-turn could make managing foreign exchange exposure more difficult.

One thing we would note is that the company is embarking on an expansive rather
aggressive push for growth at a time when the market is slowing and competition is
increasing. It is vitally important that the treasury aligns its policies to match the overall
corporate strategy of the company.

10
Question 2:

4S:

Currency on Balance Sheet: GBP

Receives Revenues in: GBP

Payments made in: EUR, CHF and USD

Airfare: USD

Accommodation: EUR, CHF, USD

(i) What risks does the above scenario create for 4S? How would you expect 4S to
hedge these?

4S Plc receives GBP from its customers but it has to pay out in USD, EUR and CHF. 4S Plc
needs to contract to purchase flights and accommodation one year in advance. This
requires 4S Plc to determine the tour prices they will offer customers one year in advance
by using the airfare and accommodation fees at the beginning of the one year period.

4S Plc is exposed to the volatility of USD, EUR and CHF versus GBP. If the overseas
currencies strengthen, 4S’s earning will be eroded if the tour prices remain unchanged
during the financial year.

In currency risks, they normally categorise the risks into three classes including translation
risk, transaction risk and economic risk. If we have to put the 4S’s risks into these
categories, we think 4S Plc is facing the transaction risk and economic risk.

Transaction risk reflects the threat of short term loss when the payment in GBP increase
due to the stronger overseas currencies meanwhile the tour prices are fixed in GBP in
advance.

Economic risk also matter 4S Plc if the sterling continues to be weakened over the long
period. It means in long run if 4S Plc receives sterling revenues but pays out on other
strengthening currency, the 4S Plc will lose its competitive advantage relative to its overseas
competitors.

There are two main windows for 4S to hedge the risks; they are internal and external
hedging methods.

11
Internal Hedging Methods:

Leading and Lagging:

It is possible for 4S to negotiate the favoured terms with its suppliers so that 4S can pay
airfares and the accommodation fees early, particularly if 4S forecasts that the GBP is likely
to weaken. By doing this, it will be easier for 4S to determine the tour prices in advance.
Nevertheless, this may be a costly way because 4S probably needs to borrow money from
banks to finance its payment and the company has to bear interest expenses during the
financial year. On the other hand, 4S can also require its customers to pay early or on an
upfront basis so that 4S can fulfil its financial obligation with suppliers earlier.

The leading and lagging method is not really popular in reality. This seems reasonable
because it will be difficult for a company to negotiate a very good payment terms all the
time.

Pricing

There are two ways to deal with pricing problem. Firstly, 4S can offer its suppliers to make
payment in GBP rather than overseas currencies. This will help to hedge the risks but in fact
transfer the currency risk to its suppliers. By doing this, 4S can remove its currency risk.
Another way is to offer floating tour prices. It means the prices will be adjusted up to the
change of currency exchange rate. This is also known as ‘margin protection clauses’.

Although pricing method is more popular than the leading and lagging method (Marshall,
2000), we still think that hedging risk internally can induce a business risk because the
competitors can adopt better business strategies to win the market as the margin of the
industry is very narrow (less than 5% as given)

External hedging methods:

In order to protect itself from the competition of its rival, 4S can consider the use of some
external hedging methods such as using the money market, forwards, futures and options.

For the money market, assuming that 4S has to make twice per year. Every six months, 4S
needs to pay out in EUR, USD and CHF. In order to set up the hedge for each currency, 4S
needs to do following steps:

- Borrow pounds for 6 months

12
 - Convert pounds into the overseas currency (each currency)
- Invest the amount of money for 6 months
- After 6 months: repay the pound loans (by using revenue), and receiving the
overseas returns on investment in the overseas currencies

For the forward contract, 4S can sign a contract to buy exactly the amount of overseas
currencies to complete its financial obligations in the future.

For the futures contract, 4S might suffer from the weakening pound, in order to hedge this
risk; 4S needs to sell forward contracts in 6 months. If 4S incurs a loss on the spot market,
this will be offset by a gain on the future contract.

It is also possible for 4S to buy option contracts. 4S is of course required to pay out a
premium and they have the right to exercise the option in the event that the overseas
currencies appreciate.

(ii) If the biggest competitor decides not to hedge any of its exposures, what risks does
this create for 4S plc?

There are two main risks affecting 4S plc when its main rival does not hedge its exposure to
currency. The first threat is the cost associating to the pricing strategy (Nain, 2005)1; and
the second threat is the dominance of the rival after earning high profits due to the positive
change in foreign exchange rate (Mello, 2004)2.

For the first risk to 4s would be that its competitor that does not risk manage reduces its
transaction cost by not paying out the hedging cost. In this case it may also be possible for
the rival to offer cheaper tour prices than 4S could otherwise offer. In addition, the tour
prices are more flexible for unhedged companies because they can adjust the tour prices
according to the actual cost (Adam, Nain, 2007). On the other hand, 4S is also exposed to an
‘unhedged’ run in the industry where all smaller competitors follow the risk management
strategy of the big rival. It means 4S may stand alone with its high price tours.

1
http://gates.comm.virginia.edu/uvafinanceseminar/2005%20Amrita%20Nain%20-
%20%20Job%20Market%20Paper.pdf
2
ftp://ftp.cemfi.es/pdf/papers/wshop/mello.pdf

13
For the second threat, we agree with the point that in case the competitor decides not to
hedge, it can take benefit from the positive change of the currency exchange rate. It means
that the competitors of 4S can benefit greatly in the event of an appreciating pound. In the
long run, the better earnings may help the rival dominate the hospitality industry though as
previously mentioned, this relies heavily on positive exchange rate movements. Should this
be the case, it will directly threaten the competitive position of 4S in the market. However,
it is crucial to examine whether the hospitality industry is unhedged or hedged one because
in unhedged industry, for example, unhedged companies usually have low profit volatility
and vice versa (Adam, Nain, 2007). For this reason, we temporarily assume that the hedging
is the normal practice in the hospitality industry, and that the main competitor follows the
strategy to achieve a volatile profit. And as mentioned earlier, this will threaten the position
of 4S in long term.

(iii) How would you manage the risk referred to in (ii) above?

When the unhedged company does employ external hedging techniques (as mentioned the
(i)), it needs to use the internal hedging tools. By adopting this strategy it takes advantage of
both positive changes of exchange rate and lower transaction costs. This urges 4S to
consider its risk management policy.

There are different types of risk management policy. They are no cover (like the main
competitor), 100% cover (assumingly like 4S plc), averaging, selective hedging and currency
trading.

From the researches of Adam, Nain and Mello, we think that in order to adopt a strategy to
cope with one of the main competitor 4S needs to consider the following issues: the
volatility of currency rates, the elasticity of demand, and the possibility of herding behaviour
in the hospitality market.

In a low volatile level of currency rates, it is may be less necessary for 4S plc to hedge the
currency. And as assumed in the previous part, we take the hedging to be a given practice in
the hospitality industry. It means the volatility of the currency rate is considerably high. Now
we only need to consider the elasticity of demand and the possibility of herding behaviour
to determine whether it is worth copying the strategy of its competitors or whether 4S can
stand alone with its own strategy.

14
We propose a matrix including the possibility of herding behaviour and the elasticity of
demand. We divided both elasticity of demand and the possibility of herding behaviour into
three levels as below:

Possibility of herding
behaviour

High Medium Low

Elasticity High (1) (2) (3)

of demand
Medium (4) (5) (6)

Low (7) (8) (9)

We try to match the suggested risk management policy and the matrix by seeing the
possible effect on 4S’s earnings.

For (1), if the smaller competitors imitate the big competitors, the prices in the market will
change frequently. At the same time, customers are eager to change their buy decision
upon the price changes, thus, a fixed price policy as 4S Plc supposed to use is not suitable
anymore because the revenue might decrease, and consequently its earnings are eroded. In
this case, we suggest 4S adopts ‘no cover’ policy.

For (2) and (3), the high elasticity of demand will drive 4S into a worse situation when
customers will most likely drift to the competitors in the face of cheaper prices (esp. the
biggest one) because the offering prices of 4S are unchanged over a period. Likewise, even
the elasticity of demand is only medium, but the trend of unhedge spread over the industry;
this can also sweep out partially the market share of 4S. Consequently, the earnings will be
considerably reduced. For this reason, we suggest 4S can use average hedging strategy so
that it can adjust its selling prices.

For the (5) and (6), as the effect on market share of 4S seems to be weaker than the
previous case, we think 4S can use the selective hedging strategy.

15
For (7),(8) and (9), as customers are assumed to exhibit a low elasticity of demand for the
products which 4S offers, there is less risk of losing market share to its competitors. The
possible gain for the big competitor is the financial income only. For the financial income, it
is different from company to company, 4S Plc can adopt a speculative strategy or 4S plc can
just fully cover its exposure by focusing on its core business. Thus, for this situation, we
suggest 4S plc follows its own strategy (i.e. hedging policy).

16
Question 3:

i. Set up a hedge, draw risk profile, add diagram effect of using option, show
cost of option on diagram

US Revenue US exporter

1.7188 1.750 $/£

Weak £, strong $ Strong £, weak $

Receive: £,
Risk: weaker £, stronger $
Hedging strategy:
Buy a put option on £, September, strike price: 1.750
Contract size: £62,500; Number of contract = £62.5m/£62,500 = 1,000 contracts.
Premium: 0.032

If the rate is greater than 1.750, option lapses.

If the rate is smaller than 1.750, exercise the option.

Breakeven point = 1.750-0.0312 = 1.7188

ii. Explain time value, intrinsic value

Future 1785 PUT

Strike 1750 Mar Jun Sep
Intrinsic value 0 0 0
Time value 68 213 312

iii. Illustrate cash flow if spot rate and future rate are $1.65/£1

Spot = $1.65/£1

Exercise the option

At spot:

$ Return = £ 62.5m * 1.65 = $ 103.125

17
At option:

Buy at 1.65

Sell at 1.75

Profit = $0.1/1£

Profit on option

($0.1 - $0.0312)*1000* £62,500 = $4.3m

Total profit in $

= $ 4.3 + $ 103.125 =

Effective rate

$107.425/£62.5 = $1.7188/1£

18
 Question 4

Introduction

Various definitions exist for corporate hedging, in short hedging is engaging in off-
balance sheet transactions by using forwards, futures, swaps and options and on-balance
sheet transactions in order to reduce the volatility of firm’s value by mitigating uncertainties
that the firm faces. An off-balance sheet foreign currency exposure hedge for a UK
manufacturer facing competition from US could include: selling a forward contract on USD,
selling a currency futures on USD, a swap where by the UK firm receives GBP and pays USD
and buying a put option on USD. An on-balance sheet hedge would be creating production
facilities in the main export country, thus offsetting a devaluation of foreign currency by
changes in production costs or borrowing in foreign currency. Stulz (1996) argues that “the
primary goal of risk management is to eliminate the probability of costly lower-tail outcomes
– those that would cause financial distress or make a company unable to carry out its
investment strategy.” We assume that he meant to say “costly lower left tail outcomes”.

The use of above mentioned derivatives has exploded over several decades with the
recent years witnessing the largest increase (however this is not to say that the volumes are
attributable to hedging only, speculation and financial firms’ activities have also grown) for
example according to CME the US Treasury 10 Bond futures average daily volume stood at
2.5 million contracts in 2006, compare this to just 205,000 in 1990 and according to ISDA the
volume of outstanding notional interest rate and currency swaps went up from $3.45 trillion
in 1990 to $285.7 in 2006 and $403 trillion in 2008.

Hedging vs speculating

Stulz (1996) notes that risk management departments often take a view on interest rates
and currencies and thus try to profit by speculation, in support he cites such disasters as
Metallgesellschaft (although some commentators disagree that the inappropriate hedging
policy was caused by bad decisions, rather by the absence of long term oil futures) and
Daimler-Benz. Some of the determinants of hedging unrelated to Financial Theory were
found by Peter Tufano (1996). He studied gold miners’ exposure to gold prices and showed
that one of the most important determinants of hedging policies was managerial ownership
of shares and the nature of the managerial compensation contracts. Therefore if

19
management owns a large proportion of shares then the firm tends to hedge more in order
to reduce the volatility of those holdings and vice-versa. The structure of remuneration
contract is also transferable to other sectors, for example if a company has a small bonus
pool, the management will not get any bonuses unless something changes quickly and
dramatically, this in turn will stimulate more risk taking based on managerial views and
expectations. According to Bartram, Brown, and Fehle (2006) also confirms that a use of a
stock option plan in a corporation can be a determinant of corporate hedging. It can reduce
manager’s risk aversion and decrease the usage of derivatives to manage firm specific risk.
Indeed very often firms that do not openly admit in speculating, actually do so. Faulkender
(2005) demonstrates that interest rate risk management practices are motivated by
speculative rather than hedging considerations. When managers swap between fixed and
floating interest rates, during changes in the yield curves, they often incorporate their own
views on future interest rate movements.

In an efficient market a corporation seeking to make a profit from its views and using
derivatives to that effect means merely raising the risk profile of its assets which does not
add value, since all information is already built in to the price and any investor would be
able to achieve a given set of risk/return characteristic for his portfolio himself. According to
Modigliani-Miler Proposition (1958) “If there are no taxes, no costs of financial distress, no
information asymmetries, no transaction costs and if investors can perform the same
transactions as companies, then the financial policies of the firm are irrelevant”. Hedging is
one of those policies and thus in an efficient market it will not add value since an individual
investor can also use hedging or hold a diversified portfolio to reduce risks. Therefore wide-
spread hedging by corporations can be considered as one of the arguments against market
efficiency. Another issue is diversification, a corporation reducing its diversifiable (non
systemic) risk will add no value to shareholder wealth since shareholders can eliminate
diversifiable risk themselves.

Determinants of Hedging – Early studies

Hedging should be used only when it creates real value and according to finance
literature there are five types of gains: reducing bankruptcy and distress costs, reducing

20
future taxes, alleviating conflicts of interest, reducing expected payments to stakeholders
and reducing costs of raising funds. We will now revue them in turn.

 When Bankruptcy costs have real costs such as lost customers, legal expenses, the
present value of these costs reduce the value of the firm, thus if hedging can eliminate
these costs it will increase the firm’s value accordingly. Hedging changes the distribution
of firm value so that default is no longer possible.
 Hedging can decrease expected taxes, when the firm is on a progressive tax scale and
thus has a convex function of its tax liabilities generated by its earnings.
 For many stakeholders such as workers, diversifying the firm’s risk is impossible (no
economies of scale), therefore they would demand a larger wage to compensate for
that. A hedging policy can alleviate this risk for that group of stakeholders.
 Decrease conflicts of interest between shareholders and bondholders
 A cost of raising funds can be high for a highly levered firm therefore it would have to
forego profitable (positive NPV) projects, through an effective risk management policy
firms can avoid situation of underinvestment.
Many studies have been concerned with the above mentioned determinants in one
way or another. One of the earlier studies was carried out by Nance, Smith Jr. and Smithson
(1993). Using a sample of 169 surveyed firms they tested three hypotheses on the
determinants of hedging. The hypothesis were based on Financial Economics and stated
that firms hedge in order to: increase firm value by reducing expected taxes; reduce the
expected costs of financial distress; reduce other agency costs. The result of their findings
showed that off-balance sheet hedging increased the value of the firm since all the three
above hypothesis hold, however with varying significance. The tax hypothesis suggested
that the benefits of hedging should be greater the higher the probability that the firm’s tax
schedule was in the progressive region, the greater the past tax deductable looses and the
greater the firm’s investment tax credits. Hedging benefits will be greater in reducing
transaction costs of financial distress where there is a greater portion of fixed interest debt
in the firm’s capital structure and the smaller the firm however larger firms are more likely
to hedge. Agency costs imply that the benefit of hedging should be greater the higher the
firm’s gearing and the more growth opportunities exist in its investment set i.e. if a
company is already highly geared and therefore its equity holders have lower residual claim

21
on assets, the benefits from a profitable investment will accrue mainly to the bondholders.
They also found that the firm’s financial policies provided a substitute to hedging, for
example the more convertible debt and/or preference shares it had, the more liquid were
the firm’s assets and the smaller the firm’s dividend payout ratio was, the larger was the
substitute for hedging, lower leverage and shorter debt maturities also had the same effect
of reducing hedging. However their results were inconclusive (a significant but very small
coefficient) in supporting the tax and leverage hypotheses.

Changes in financial reporting standards in the early 1990s required firms to disclose
off-balance sheet financial tools used for hedging in the accounts footnotes. This gave an
opportunity to undertake broader study and statistical tests of corporate hedging policies
that were not possible before.

Determinants of Hedging – Later studies

In 1996 Shehzad and Mian published a study that used a sample of 3,022 firms. In it
they acknowledge the results of previous studies including the Nance, Smith and Smithson
(1993) and expand on those. They find that the larger the firm is, the more incidence of
hedging is observed (a relationship cited by many other studies afterwards), thus showing
that economies of scale are present in hedging, something that the previous study failed to
note. In terms of taxes they note that hedgers have lower incidence of progressivity (firm
size also points to this) and even though foreign tax credits (proxy for tax shield) are
significant, evidence related to tax as a whole appears to be very weak. Hedgers do not have
a high market-to-book ratio (a proxy for investment opportunities – “investment
opportunity set”) and this is primarily driven by interest rate hedgers, however this
relationship varies across the type of risks hedged.

In terms of financial policies, hedging was found not to be related to leverage (book
value of debt / (market value of ordinary stock + book value of preferred stock)) as higher
leverage would mean that taping into capital markets would be more expensive, and neither
was it related to liquidity (current ratio). But hedging found to be related to dividend yield
and the dividend payout ratio. Also differences between interest risk and currency risk
hedgers was discovered: Interest risk hedgers have higher leverage and longer debt
maturities while currency hedgers have lower leverage and shorter debt maturities.

22
 So far in the above mentioned studies we have encountered two somewhat different
results regarding taxes i.e. Nance, Smith and Smithson point out that firms tax more on a
progressive scale, but those are smaller firms which hedge less, and even though the
relationship is positive it is not significant also they find no relationship between leverage
and hedging, while Graham and Rogers (2002) confirm the results of Shehzad and Mian that
taxes are irrelevant in determining hedging policy. They found that there is no relationship
between tax function convexity and hedging. And as also reported by Ammon (1998), this
absence of relationship holds both in UK (unlimited loss carry forward) and USA (20 years
limit on loss carry forward). The second tax related issue they examined related to
increasing debt capacity (interest payments as tax shield) or leverage, here they showed
that by hedging firms can increase debt capacity and as a result – firm value. This benefit is
derived from two sources: firstly lower volatility of earnings allows for greater leverage with
consequently greater tax benefits and secondly “lower expected default rates” and financial
distress costs as a result of unused debt capacity. That is debt capacity grows but only a part
of it is utilised, which results in increasing firm value. Géczy, Minton and Schrand (1997) and
others also find that leverage is one of the most statistically significant variables as a
hedging motivation.

An International Perspective

An International study conducted by Bartram, Brown, and Fehle (2006) examined

7,319 firms in 50 countries (80% of global market capitalisation of nonfinancial companies).
Using a large sample they hoped to resolve some of the conflicting conclusions from the
prior studies.

Their results were consistent with the financial distress and tax hypotheses, where
hedgers have higher leverage and income tax credits and lower liquidity (quick ratios) and
less tangible assets. However, other results were not consistent with the financial distress
hypothesis. In particular the relationship between the size of the company and its hedging
did not hold, also longer debt maturity, and higher interest coverage ratios also failed. Also
the study’s univariate results do not generally support the underinvestment hypothesis
either as hedgers have lower market-to-book ratios (recall that this is our proxy for growth
opportunities, as the market prices in those opportunities the PE ratio also grows) and

23
capital expenditures and tend to be less R&D intensive. However, hedgers are more likely to
be growth firms with high debt levels.

Also there was little support for the managerial incentives hypothesis.

On international scale the evidence suggests that market access is likely to be very
important. Hedgers are more often located in countries with larger derivatives markets,
higher GDP per capita, and OECD countries. Other results again reveal mixed evidence for
theoretical predictions. Evidence also suggests that hedgers are likely to be in politically safe
countries as measured by various indices. Hedgers tend to be in countries with better
shareholder rights and less concentrated equity ownership

For FX derivatives, income tax credits and the relationship between market-to-book
and leverage are not very significant. For IR derivatives, profit margin and income tax credits
are not significant.

Problems with samples

It seems that evidence on the main determinants of hedging is not always

conclusive. Guay and Kothari (2003) suggest that firms use derivatives to “fine tune” their
hedging policies which might be predominantly on-balance sheet, thus suggesting that
derivatives create a lot of noise which in turn creates problems for empirical tests related to
underinvestment and financial distress. Another problem relate to measuring the exposure
to derivative contracts, as noted by Judge (2006) some studies focus on the fair value of the
derivative scaled to the firm’s size, this figure is the amount at which the instrument can be
exchanged between the willing parties and is calculated by discounting the future cash flows
to NPV. The fair value of a derivative contract at origination is zero, even though the firm
might be fully hedged. Notional amounts used for measuring hedging, don’t paint an
accurate picture either, as those studies fail to account the risk characteristics of the
contract.

Conclusion

Before the changes in financial reporting standards scholars had to utilise sample
surveys, which caused an obvious problem of non-response, after the early 1990s, as firms

24
started reporting their hedging policies, a lot of data started to become available and
research into hedging really took off. However many scholars still report that much of
potential research areas still exist. In this paper we examined the main determinants of off-
balance sheet hedging to be financial distress, agency problems, financial structure, taxes
and underinvestment in many cases those determinants are connected for example taxes
and financial structure of the firm (leverage). We examined on-balance sheet hedging
alternatives and financial policy alternatives which alleviate the need for hedging. We also
discussed managers’ motivation to hedge or to take on risks by taking views and
speculating.

25
Question 5:

i. Describe the forward position one would enter into and determine the C$
value of the payable if you lock in using a forward contract.

Buy a forward contract,

C$ payable = 1.4855 * US$ 1.85m = C$ 2.748175m

ii. Describe the money market hedge for this situation.

9M (based on 365 day Deposit Lending

basis)
C$ 1.125 1.20206
US$ 0.7397 0.80137

Borrow US$ 1,835,292.516

Convert into C$ at 1.4875 = C$ 2,729,997.618
Invest into money market in 90 days, returns = C$ 2,764,122.588

Repay US$ 1,850,000

Effective rate
C$ 2,764,122.588/US$ 1,850,000 = 1.4941 C$/ 1 US$

iii. Describe the option hedge for this exposure.

Option on C$ - OTC option.

Receive: US$
Risk: weaker US$, stronger C$

Buy option, premium: 2.5% on C$ value at strike price.

Total premium = 2.5% * US$1.85m * (1/0.625) = C$ 0.074m

C$ Canadian exporter

US$/C$

Stronger US$ Stronger C$

Weaker C$ Weaker US$

26
iv. Determine the exchange rate, C$/$, at which the option hedge would
produce a better outcome for the firm than the forward hedge and the
exchange rate at which the option would be better than being unhedged.
Option vs. forward

Call X is spot rate which is smaller than strike price 1.6 C$/ 1US$

Return at spot:
US$ 1.85m * X
If X is smaller than 1.6, the profit will be:

1.6 * US$ 1.85m – 2.5%* US$ 1.85m * 1.6 (premium paid at the end of period)

Total profit will be

C$ 1.85m *X + C$2.886 m

Forward contract return is C$ 2.748175m

So, the option is always better than the forward contract.

Hedged vs. Unhedged

The strike price is C$ 1.6/1US$

The premium is 2.5% of face value = 2.5% * US$1.85m* 1.6 = C$ 0.074m

The premium on 1 USD = C$0.074/US$1.85 = C$0.04/US$1

The spot rate at which the hedged position is better than unhedged position is:

X < (1.6 – 0.04) = C$1.56/1US$

27
Reference:

Adam T. R., Nain A., (2007), Strategic Risk Management and Product Market Competition

Amrit Judge, 2006, “Why Do Firms Hedge? A Review of the Evidence”, Economics Group
Middlesex University Business School

Deana R. Nance, Clifford W. Smith, Jr., Charles W. Smithson, 1993, “On the Determinants of
Corporate Hedging”, The Journal of Finance, Vol. 48, No. 1 (Mar., 1993), pp. 267-284

Faulkender, M., 2005, “Hedging or market timing? Selecting the interest rate exposure of
corporate debt”, Journal of Finance, Vol. 60, 2005, pp. 931-962

Guay, W. and Kothari, 2003, “How much do firms hedge with derivatives?”, Journal of
Financial Economics, Vol. 70, 2003, pp. 423-461

John R. Graham and Daniel A. Rogers, 2002, “Do Firms Hedge in Response to Tax
Incentives?”, The Journal of Finance, Vol. 57, No. 2 (Apr., 2002), pp. 815-839

Mello A. S., Ruckes. M. E., (2004), Hedging and Product Market Decisions, University of
Wisconsin-Madison

Nain A., (2005), The Strategic Motives for Corporate Risk Management, Job Market Paper

Norbert Ammon, 2006, “Why Hedge? A Critical Review of Theory and Empirical Evidence”

Shehzad L. Mian, 1996, “Evidence on Corporate Hedging Policy”, , The Journal of Financial
and Quantitative Analysis, Vol. 31, No. 3 (Sep., 1996), pp. 419 -439

Stulz, R., 1996, Rethinking risk management, Journal of Applied Corporate Finance 9, 8-24

28