1.0 The pros of risk management
Adverse changes in interest and exchange rates may reduce the competitive position of a company against those with lower levels of gearing or smaller exchange rate exposures, or compared with companies that have taken the precaution of hedging against rate changes.
Reduction of bankruptcy risk
Adverse movements in interest and exchange rates may jeopardize the continued operation of a company. A classic example is that of a highly geared company with a large proportion of floating rate debt being forced into bankruptcy due to an increase in interest rate.
Restructuring of capital obligations
Interest rate hedging instruments can be used to restructure a company’s capital profile by altering the nature of its interest obligations, thereby avoiding the repayment of existing debt or the issuing of new securities. In consequence, considerable savings can be made in respect of call fees and issue costs. At the same time, a wider range of financial sources becomes available to the company.
Reducing in the volatility of corporate cash flows
Reducing the volatility of net cash flows may increase the market rating of the company and will facilitate the process of forward planning.
2.0 The cons of risk management
The complicated nature of hedging instruments
A combination of unfamiliarity with the range of hedging methods available and a belief by potential users that such methods are complex may result in treasurers choosing not to hedge exchange and interest rate exposures.
The risks associated with using external hedging instruments
The perceived risk associated with in using hedging instruments can sometimes dissuade potential users. Instead of providing protection from steeply increasing interest rates, the transactions turned out to be highly speculative bets.
The complicated tax and financial reporting treatments of derivatives
The accounting and tax treatment of derivatives has tended to lag behind the pace of their development owing to the dynamic nature of their markets. The major problem regarding the accounting treatment of derivatives is knowing exactly what information to disclose and how to disclose it.
Diversification by shareholders may be superior to hedging
An alternative to hedging by individual companies is for shareholders to diversify away interest and exchange rate risk themselves by holding a diversified portfolio of shares, hence saving the costs associated with hedging at a corporate level. If shareholders hold diversified portfolios, some commentators argue that hedging of exposures by individual companies is motivated purely by management’s desire to safeguard their jobs, rather than a desire to enhance shareholder wealth.
As a conclusion, exchange rate risk and interest rate risk can be managed by the use of both internal and external techniques. Internal techniques allow companies to hedge risk within their own balance sheet by the way in which they structure their assets and liabilities. Alternatively, companies can employ one or more of the many external techniques now available, such as swaps, options, futures and forwards. While these derivative instruments give more scope and flexibility to companies to manage their risk, their associated costs and their complicated nature must be taken into account.