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Discuss the case for hedging and the case against it, including any effect hedging has on a firm's profitability.

FRM® Part I · Financial Markets and Products · Using Futures for Hedging · FRM1.FM.8.b

The idea

The case for hedging is that it reduces uncertainty in cash flows. This helps planning, lowers the chance of financial distress, protects investment spending and can cut expected taxes when the tax schedule is convex. The case against is that shareholders can diversify or hedge on their own account, and that hedging costs money and managerial attention. Firm-specific risk also earns no risk premium, and a hedge can leave the firm worse off than competitors who did not hedge. A hedge removes variability, not expected profit. If the price moves in the firm's favour the futures lose, and the hedged outcome is lower than the unhedged one. Judge a hedge by its purpose, not by hindsight on the outcome.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a standard argument against corporate hedging?

  1. Shareholders can diversify or hedge firm-specific risks on their own account - correct
  2. Hedging increases the volatility of the firm's cash flowsWhy not: Reverses the purpose of hedging, which is to reduce cash-flow variability, not increase it.
  3. Futures prices are biased predictors, so hedging always loses money on averageWhy not: Fairly priced futures have no systematic bias; this confuses a speculative view with the argument against hedging.
  4. Accounting rules prohibit non-financial firms from using futuresWhy not: No such prohibition exists; hedge accounting affects reporting treatment, not whether firms may hedge.

Shareholders hold diversified portfolios and may hedge themselves, so a firm's hedging adds cost without adding value in the eyes of such investors.

A harder one

A cable maker's selling prices move one-for-one with the copper price, and it buys copper at spot. Unlike its competitors, it hedged future copper purchases with long copper futures. Copper then falls sharply. What is the likely effect on its profit margin relative to competitors?

  1. Its margin is protected, because the lower copper cost offsets the futures lossWhy not: The cost saving is passed on to customers as lower selling prices, so it does not offset the futures loss.
  2. It earns a lower margin, because its futures loss is not offset by any change in its selling price - correct
  3. Its margin is the same as competitors, because futures prices equal expected spot pricesWhy not: Equality in expectation does not make realised outcomes equal; the futures loss is real and competitors do not suffer it.
  4. Its margin is unchanged, since the hedge fixes the copper costWhy not: Fixing the cost is irrelevant when the selling price falls with copper: the margin was already naturally hedged.

With price pass-through the firm's margin was naturally insulated; the long futures add exposure and lose when copper falls, so hedging increased margin variability and cut profit relative to rivals.

The hardest tier

A firm's pre-tax profit next year will be either USD 100 million or a loss of USD 40 million, each with probability 0.5. Tax is 30 percent of positive profit; losses receive no refund or carry-forward. A hedge would fix pre-tax profit at its expected value with certainty, and hedging costs are ignored. By how much does hedging raise expected after-tax profit?

  1. USD 6 million - correct
  2. Zero, because the hedge leaves expected pre-tax profit unchangedWhy not: Ignores the convex tax schedule: equal expected pre-tax profit still gives different expected tax.
  3. USD 9 million, the tax paid in the hedged caseWhy not: Reports the hedged tax bill (30 percent of 30) rather than the change in expected after-tax profit.
  4. USD 15 million, the expected tax without hedgingWhy not: Reports the unhedged expected tax rather than the difference between hedged and unhedged after-tax profit.

Expected pre-tax profit = 0.5 x 100 + 0.5 x (-40) = 30. Hedged after-tax = 30 x 0.7 = 21. Unhedged: 0.5 x 70 + 0.5 x (-40) = 15. Gain = 6. Convex taxes make smoothing profit valuable.

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