In these days of risk and uncertainty, I am sure that many companies will be on the lookout for ways to hedge against risk, and they will find plenty of entities willing to tell them how to do it or sell them products or services that provide protection. After all, every macro uncertainty from interest rates to inflation to commodity prices can be hedged using derivatives or insurance. But is this a good idea?
In my book on risk, titled "Strategic Risk Taking", I have argued that the essence of good risk managment is separating risk into three buckets:
a. Risk that should be passed through to investors, because they either want to be exposed to this risk or because they can protect themselves at a far lower cost. Included in the first group would be commodity risk to a commodity company: investors buy stock in oil companies because they want to make a bet on oil prices. An oil company that hedges against oil price risk is undercutting that bet. Included in the second group would be risk that cuts in different directions for different companies. I think it is generally a bad idea for companeis to hedge against exchange rate risk, simply because a stronger dollar helps some companies and hurts others. As an investor with stakes in both Coca Cola and Boeing, I think about exchange rate risk in my overall portfolio (which I can choose to hedge if I want to) rather than in individual companies.
b. Risk that should be avoided/ hedged: This would include risks that are not easily visible or difficult to hedge for investors in the firm, but are large enough to affect it's operations or survival. Included in here would be the risk of physical damage to property (against which you can buy insurance) and the costs of inputs into the production process. Thus, there is a rationale for an airline buying oil price futures to lock in the cost of fuel, Not that the action will not make the firm more profitable over time but may improve its operating efficiency; the airline can set ticket prices, knowing what their costs will be, and focus on improving efficiency in areas where it can make a difference.
c. Risk that should be sought out and exploited: Firms become successful by seeking out and exploiting risks and not be avoiding them. However, they have to find those risks on which they have a competitive advantage to do this. This is where corporate strategy meets corporate finance/ risk management. The edge could be technology, brand name or information...
Since this post has become way too long, I will leave you with questions about risk hedging/taking in general that you can try answering with this framework (if that is how you want to waste your day):
- Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense?
- In the last two years, other airlines that have never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense?
- A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense?
- As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea?
- A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense?
- Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think?