Understanding the strategic benefits of hedging

The benefits of hedging FX are well known by financial officers, but less thought is given to why strategically it is a good practice.

In short, hedging activities can add significant value to a company’s operation. It can increase pricing stability, enhance a company’s valuation, and improve the ability to raise both debt and equity capital. It can also reduce taxation, or lessen uncertainty when entering new markets. For anyone involved in foreign exchange, these benefits cannot be ignored.

Pricing Stability

Pricing stability results from hedging cash flows and there are two main benefits from this. Firstly, for those goods which are imported for sale, there is less volatility in the cost of goods sold. Secondly, for goods that are exported and sold in foreign markets, a stable price can be maintained in the local currency, which means a more level playing field with the local firms. Both of these points help raise the future earnings value of a company.

But there are also broader benefits, which include a strengthening of a company’s brand and reputation as customers come to rely on the price stability, as opposed to other competitive firms who do not hedge, having to change their prices more often.

Corporate Valuations

Corporation valuations are another benefit of a properly conceived hedging strategy. This is mainly down to the salutary effects of earnings stability on multiple corporate measures. For example, hedging has the ability to exploit a market value when calculated against the unmeasured, or unrecorded assets of the company. Here’s a simple example. If a share price of a company is £2 and the capital price is £1, the management can issue new shares and profitably invest the capital raised. There is a generally accepted hedging “premium” – added firm value due to hedging – of between 5-10%.

Higher valuations of course also enhance a company’s capacity to make a sound acquisition. Acquisitions are funded from multiple sources, which include stock swaps. In other words, the company which is making the acquisition uses its own stock to pay for the company being bought. It follows therefore that if sound hedging policy leads to a higher valuation for a company, then the ability of the company to make acquisitions is boosted.

Raising Capital

Successful strategic hedging increase’s a company’s ability to raise capital for expansion and investment is increased with hedging. Bear in mind that there are two main sources available to a company: the equity market and the debt market.

When it comes to the equity, a popular way to make an investment decision is to use the popular Sharpe ratio which takes the expected value of the rate of return minus the risk free rate and divides that result by the standard deviation of the return. This reflects how well the return compensates the investor for the risk taken (standard deviation). Hedging raises the Sharpe ratio for any level of earnings, because reducing earnings variation will reduce the standard deviation. Thus, the attractiveness to investors is boosted.

Let’s take the debt market. Hedging increases a company’s ability to borrow, mainly because the resulting stable cash-flow makes the repayment of debt a stronger likelihood. This fact has been borne out of detailed research. Clearly, hedging can help stabilise earnings and reduce volatility, which means it’s far easier to predict future earnings, on which the raising of debt can be achieved.

Taxation

Hedging has a positive impact upon taxation in two ways: firstly, tax convexity and secondly, the effect of increased debt capacity and the tax deductibility of interest. Looking at tax convexity first, the function that maps income into tax liability is convex for most companies. Hedging results in reduced income volatility which provides companies with the opportunity to reduce their tax liabilities.

Next comes the question of the effect of the increased debt capacity and the tax deductibility of interest, which is much larger than convexity. It is well known that leverage has a positive influence on both IR and FX derivatives. For most companies, hedging with currency derivatives increases the available debt ratio by 4.52%, with the capitalized value of the incremental tax shields resulting from this increased debt equalling 1.4% of the company’s value.

Entry Into New Markets

As companies grow, they are drawn into the opportunities offered by developed and emerging economies. This immediately increases the exposure to foreign exchange volatility. Realistically, the only way to counter this volatility, especially when dealing with the fast-growing regions of say China, Brazil, or India, is to create long-term hedging solutions. If these are not activated, then revenue forecasts and projections can be sunk by adverse currency moves.

Such techniques might include natural hedging which can be used to offset some of the start-up costs when starting a new operation overseas. And from natural hedges, which cannot hedge the exposure completely, things can progress smoothly onto derivative cash flow hedging.

Final Word

Given the points and benefits highlighted above, it’s important for all company executives who might be involved in the Forex process to understand not only that the fact that hedging works, but also the strategic reasons why it works. For once the Forex team has good visibility, they will be able to understand the true implications of sensible hedging policies.