Cost And Benefit Of Hedging Risk Using Financial Derivatives

926 words - 4 pages

Finance theory does not provide a complete framework for explaining risk management under the fluctuated financial environment in which firm operates. Hence, for corporate managers, they rank risk management as one of their top priorities. One of the strategies to reduce risk is by hedging. This paper will discuss the advantages and disadvantages of hedging risk using financial derivatives.

Hedging depends across various motives. For example, if a manager intends to minimize corporate taxes, he will hedge taxable income. Stulz (1984) and Smith and Stulz (1985) indicate that progressive tax rates and consequently convex tax schedules cause the firm’s expected tax liability to rise with variance of taxable income, indicating that hedging boosts firm value by decreasing the present value of future tax liabilities. If the corporate managers’ main concern to reduce financial distress costs and if the manager can faithfully communicate the company’s probability of default, the manager’s strategy will concentrate on the market value of debt and equity.

Hedging risk has two sides, such as advantage and disadvantage. The main benefit of hedging is to help reduce risk of financial distress that firm might face, and it helps firm to insure themselves from negative event which could lead to financial distress, such as: Inflation, currency rate volatility and interest rates changes. Moreover, it could protect company from distress to the extent where reducing distress cost exceeds the cost of hedging which will increases the value of the firm.

The second advantage would be more money generated by firm who hedge; hedging actually can reduce the firms’ value debt ratio and increases their level of debt capacity (Kale and Noe, 1990). Firm who has less distress cost later on will tend to borrow more, as long as borrowing bring tax advantage toward firm, firm will then borrow more money and have lower cost of capital.

Hedging also benefit firm through tax benefit. When firm choose to risk hedging, it means some of their income will be lower compare to if they do not hedge. With lower income it means that there will be less tax that firm should pay, firm than could benefited by the tax saving even though the hedging cost do not included.

On the other hand, hedging strategy requires a lot of money, which could lower firms’ overall profit. There are several costs that firm need to incur when they want to hedge, including: margin money and maintenance margin money. Another point is as hedging helps firm to reduce the risk investment, it will also reduce the firms’ potential profit earned, as higher risk means higher potential profit.

Moreover, many firms are using financial derivatives, a form of business negotiation between parties, to hedge the risk. Financial future and forward contracts are basically an agreement where...

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