Risk Hedging Framework: cost/benefit and cheaper to retain

[khaled binhotan]

Can you please explain the second point '' • The total cost (including responsibilities) for hedging the cost are less expensive for the firm than for its investors (as the alternative is to “pass along” the risk to
investors)"?
thanks,

 

[David Harper CFA FRM]

Hi khaled,

It's a good question because the IFC paper does not give enough context to explain the point. I copied the section from the IFC reading below. They are paraphrasing Rene Stulz (as betrayed by the reference to a gold mining company); Stulz's Chapters 2 and 3 were assigned in the FRM for several years, but recently discontinued.

The first idea is the so-called hedging irrelevance proposition, which says: under a CAPM framework (which makes several unrealistic assumptions), there is systemic risk and diversifiable (non systemic) risks, and if markets are perfectly efficient, the firm cannot create (add) value by hedging because capital markets have a "comparative advantage" in bearing the firm's risks.

The second idea undoes the first and depends on a violation in the assumption of perfect markets. Because markets are not perfect, the hedging irrelevance proposition is not true in practice. Due to market imperfections, risk management can add value, and this includes the advisability of the firm hedging its own risks in some cases (versus having capital markets bear theses risks, which under the H.I. proposition would be preferable in all cases!). Two examples:

1. A large un-diversified shareholders such as a private equity firm: unlike a classically diversified shareholder, firm-specific (non systemic) risks are not "free" and might be expensive for this investor to hedge. Here, it may be cheaper for the firm to hedge
2. Information asymmetries and agency costs of managerial discretion: a firm, due to information advantages, may be able to put on a hedge cheaper than its shareholders; e.g., maybe the firm can finance a project internally which diversifies the firm (the hedge need not be a derivative, it can be a simple as organic diversification due to different projects) and the firm can secure favorable financing

Here is IFC context:

Fundamentally, it makes sense for firms to hedge a risk if both of the following conditions hold:

• The benefits of hedging the risk exceed the costs: Bringing together the tax benefits, the reduced distress costs, and improved investment decisions, do the benefits exceed the costs? If the answer is no, the firm should not hedge that risk.
• It is less expensive for the firm to take responsibility for hedging the risk: Even if the benefits exceed the costs, the firm has to follow up by examining whether it is less expensive for the firm to hedge this risk or whether it makes more sense for investors to hedge on their own. For example, firms facing exchange rate risk can choose to hedge this risk, but it might be less expensive for institutional investors to do so on their own, since some portion of the risk could be eliminated by the portfolio

 

[machaang]

Hi David,
I have a question about the Hedging Decision Value. The formula only takes the cost of equity as the discount factor. As our effort is to check whether it is worth for us to hedge the "firm" risk, why we only consider cost of equity not cost of capital WACC?
Thank you
SB