How and why do companies hedge?

Should companies use derivatives to hedge? How and why do companies hedge?

So in today’s video we’re going to discuss why companies hedge and whether it makes sense for them to do so or not this video is part of a longer series and finance videos about financial derivatives if you’re interested in that topic you might find some of my other videos interesting i’d like to start this video off with a question i usually ask my students when

We first start learning about hedging with derivatives if there’s an american manufacturing company and it buys all of its supplies locally in u.s. dollars they’re made in america priced in dollars they sell all of their goods to american consumers once again who pay in us dollars and they pay all of their staff all of their american staff in us dollars does this

Company have any foreign exchange risk in class when asked this question i usually ask for a show of hands and often about half of the class say yes and the other half say no well that’s not really true most try to avoid raising their hands and half of the people who do raise their hand say yes and the other half say no but anyhow it would it would often up here

You know on first look at this question it would appear that the answer is no because there’s nothing really falling going on it’s it’s all american and it’s all dollar denominated but the answer is actually yes the company does have foreign exchange risk and think about it for a moment and then i’ll tell you why the reason that the company does have foreign

Exchange risk is actually just if they have one foreign competitor so how does that work well if the if the price of the foreign currency falls in relation to the us dollar the foreign competitor has a cost advantage in terms of labor cost and maybe even in raw materials cost as well and does they can undercut the us companies prices and potentially take business

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From so the truth what we’re kind of learning here is that every company in truth is exposed to risks like foreign exchange risk and so then we’re left with the question whether that company should hedge that foreign exchange risk or not now in the above example i would say that they probably shouldn’t spend their time hedging that risk because it might just be

Too complicated and unproductive to hedge global currency risks for you know a manufacturer of wilson’s simple goods but it’s worthwhile still being aware of the risks that your company is exposed to so that then leads us to the question of why should companies hedge their exposures most companies produce goods or provide services and may not have particular skills

In predicting market prices things like interest rates exchange rates commodity prices and so on if these prices are important drivers of the company’s costs often it might make sense to hedge those cut those exposures just to reduce business uncertainty so that the company can focus on being the best they can at their core expertise of manufacturing goods or

Services many academics and investors argue that shareholders can in fact just hedge themselves individually if they want to hedge against certain market exposures and that therefore the companies that they invest in should not be hedging because investors might have will say a good example is investors might have invested in a gold mining company because they

Felt that the price of gold was going to rise and so they might be unhappy to find out that the gold mining company was actually hedging their gold exposure and thus when the price of gold went up the investor does not actually get the gains they were hoping for this is a good argument it’s a reasonable argument and it’s reasonable to say that the investor can

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Protect themselves from x exposures to certain economic variables either through holding a diversified portfolio or through hedging the exposures themselves this of course ignores the fact that hedges are usually cheaper if done in size so it’s cheaper for a gold company to hedge their overall gold production than it is for an investor who might own 100 shares

In that company to invest whatever their portfolios gold exposure is the other argument and the real argument for a company doing at least some hedging is that it allows them to have some visibility of future prices and thus allows them to make more long-term business plans so let’s look at an example of that we’ll say for example a breakfast cereal company they

Might decide on the pricing of a box of oatmeal one year in advance they might design a box they’ve printed the price of the oatmeal on that box and they might be printing that box a year in the future it’s gone out to graphic designers it takes some time so if they were unable to hedge their short-term exposure to the price of oats it might make things quite

Difficult when negotiating pricing with supermarkets and their customers might find it annoying to see the price constantly moving around every time they go to the supermarket because of increases or decreases in the price of a basic commodity so the company might also have difficulty making any kind of long-term plans or projections in in building a business

Plan when their profit margins are entirely unknown because the profit margin changes as the price of the underlying commodity changes so how do companies then hedge short futures hedges are usually used when the company owns the asset already and expects to sell it in the future so examples are farmers gold mining company petroleum producers the companies like

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That then long futures hedges are used when the company knows that it will have to purchase that asset in the future so an example of that would be a breakfast cereal company like we just talked about who need to purchase grains or we’ll say an airline company that leads to purchase jet fuel in order to operate its fleet of planes so hopefully that’s explained

To you whether companies should hedge the pros and cons a little bit of hedging and how people heads with futures now in a future video we’re going to look at options and how they can be used in hedging let me know in the comment section below what you think about companies hedging when does it make sense when is it a waste of time these videos are all based on

My book and if you’re interested in them you might also be interested in the book there’s a link to it in the description below if you found the video helpful please hit the like button please subscribe if you’d like to see more and as i said feel free to comment and let me know if there’s any other topics you’d like me to cover have a great day and i’ll talk to you soon bye

Transcribed from video
How and why do companies hedge? By Patrick Boyle

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