Case 1: Currency Price Risk: The Multinational Corporation

At the end of 2007, Coca-Cola Company generates revenues in more than 200 countries. Given the multinational flavor of its operations, it is natural to expect Coca-Cola to be significantly affected by currency fluctuations. Box 18.1 shows the general currency risk disclosure contained in Coca-Cola’s 10-K filing for 2007.¹

Coca-Cola’s operating revenues are flavored in 67 currencies other than the U.S. dollar, and 74 percent of its operating revenues are derived from outside the United States. Between 2006 and 2007, Coca-Cola’s net operating revenues increased by 20 percent, of which one-fifth of the revenue gain was attributed to the weakening U.S. dollar (see page 47 of the 10-K filing). While the weaker U.S. dollar also contributed to increases in selling, general, and administrative expenses, the overall effect of the weaker dollar contributed positively to Coca-Cola’s operating income (see page 51 of the 10-K filing). The implication from Coca-Cola’s 2007 results is that, in the future, weaker foreign currencies could possibly reduce the company’s reported earnings and cash flows.

How does Coca-Cola manage the risk of its currency fluctuations? In footnote 12 of its 10-K filing for 2007, the company discloses:

We enter into forward exchange contracts and purchase foreign currency options (principally euro and Japanese yen) and collars to hedge certain portions of forecasted cash flows denominated in foreign currencies.

In 2007, Coca-Cola reported no other material derivative contracts (such as interest rate or commodity). Its disclosures provide no detail as to the extent of exchange rate contracts traded during 2007 or held as of the end of 2007. However, it appears that the weakening U.S. dollar did not cause a great deal of derivative losses for Coca-Cola in 2007 (presuming that the company would hedge against a strengthening U.S. dollar). Coca-Cola discloses a $64 million net loss on derivatives in Accumulated Other Comprehensive Income during 2007 (see Coca-Cola’s Statement of Shareowners’ Equity on page 69 of its 10-K filing). Relative to its 2007 reported net income of almost $6 billion, this loss on foreign exchange derivatives is quite small (about 0.1 percent of net income).

Case 2: Interest Rate Risk: The “Heavy-Debt” Firm

Comcast Corporation had more than $31 billion of debt outstanding at the end of 2007.² Its debt load created $2.3 billion of interest expense during 2007. Meanwhile, the company generated approximately $5.6 billion in operating profits. Comcast regularly borrows additional funds to finance its operations with more than $11.2 billion of new debt during 2006 and 2007, while it repaid $3.4 billion of outstanding loans.

Although Comcast does not provide clear discussion in its 10-K filing as to the composition of its interest rate risk, the implication is that Comcast considers both cash flow and market value effects of interest rate fluctuations. In other words, some of its interest expense is variable over time (i.e., cash-flow risk), while debt with fixed interest expense will vary in market value as interest rates change (i.e., market-value risk).

At the end of 2007, Comcast managed its interest rate risk by entering into interest rate swap contracts by which the company pays a variable rate while receiving a fixed rate. Comcast holds interest rate swaps with combined notional values of $3.2 billion, and the contracts mature between 2008 and 2014. In essence, by converting approximately 10 percent of its overall debt to floating-rate debt, Comcast is reducing the market value risk of its existing debt. Over the course of the time span from 2006 year-end to 2007, the company’s average pay rate on the swap has declined from 7.2 percent to 6.8 percent (while the average fixed “receive” rate is 5.9 percent). The market value of the swap contracts has increased by $120 million from ($103 million) at year-end 2006 to $17 million at the end of 2007. This market value increase in the swap offsets Comcast’s opportunity loss on its fixed-rate debt as variable interest rates decline.

Case 3: Commodity Price Risk: The Firm with a Highly Volatile Input Cost

In 2007, jet fuel costs comprised 28 percent of Southwest Airline’s operating expenses.³ The spot price of jet fuel has approximately tripled between the end of 2002 and 2007, and this fact is only partially reflected by an increase in Southwest’s average per gallon fuel cost from $0.72 during 2003 to $1.70 during 2007.⁴ In other words, Southwest’s average fuel cost has only increased by 2.36 times rather than the 3 times implied by the increase in spot jet fuel prices. How has Southwest limited growth in its fuel costs?

Southwest Airlines has managed to partially mitigate the effects of rising jet fuel prices by entering into hedging transactions that benefit from higher crude oil and refined products prices. During 2007, the company realized $727 million in cash settlements from derivative contracts previously entered into for the purpose of hedging jet fuel price risk. These gains are a critical element in Southwest’s reported 2007 net income of $645 million.

Hedging Reduces Expected Costs of Financial Distress and Underinvestment

One commonly cited benefit of an effective financial hedging program is that it should reduce the probability that the company encounters financial distress. This fundamental argument was first made formally by Smith and Stulz (1985). Fundamental business valuation principles such as discounted cash flow ignore the potential effects of distress because the onset of distress is not assumed to affect expected cash flows (rather it is just one potential outcome of the cash flow distribution), and distress is an idiosyncratic risk so the cost of capital does not incorporate the effects of distress. As such, an extended business valuation model reflects the present value of expected future cash flows minus expected distress costs. Although a firm can likely do little to change costs incurred if distress occurs, the firm can reduce expected distress costs by reducing the probability of encountering financial distress. Therefore, a firm that effectively reduces its probability of encountering financial distress by hedging financial risk should be awarded a higher valuation than if unhedged.

Financial distress costs are often interpreted as consisting of the costs associated with bankruptcy (such as legal and accounting fees, and management time directed toward dealing with bankruptcy procedures rather than toward managing the business). However, one of the most pervasive costs associated with financial distress is the value lost because of a firm’s inability to take advantage of valuable investment opportunities. This type of problem is often referred to as the “underinvestment problem.” Froot, Scharfstein, and Stein (1993) developed a formal model to illustrate how a firm’s financial hedging decisions can help it avoid the potential for underinvestment. In particular, if the realization of a risk exposure causes a firm’s operations to yield lower operating income, the firm may choose not to take a valuable investment opportunity because of a lack of internal capital and poorer access to outside capital. On the other hand, if the firm had previously entered into a financial hedge that offsets the risk exposure, then the profit on the hedging instrument provides additional cash flow to the firm. If this cash flow is then used to invest in a valuable investment opportunity, the underinvestment problem is solved and firm value reflects the positive value of the investment.

Empirical studies of corporate hedging are generally supportive of the financial distress cost hypotheses (including the underinvestment costs hypothesis); however, the findings are far from unanimous.⁶ In general, there is sufficient evidence to believe that many firms find hedging to be beneficial in reducing expected costs associated with financial distress and underinvestment.

Hedging Creates More Debt Capacity

If hedging of financial risk reduces a firm’s probability of distress, its optimal action might be to increase its debt. Leland (1998) theorizes that the primary benefits of reducing risk by hedging are the incremental tax benefits accruing from additional debt after the firm readjusts its capital structure. In general, this line of thought suggests that hedging creates value because extra debt allows for additional tax benefits or is used to finance valuable investment opportunities.

Graham and Rogers (2002) provide the first substantive evidence that the “debt capacity” argument for hedging financial risk is important on average. They find that an “average” user of interest rate and/or currency derivatives has a higher debt ratio than a nonhedger of financial risk, and that the higher debt ratio provides more than 1 percent extra value, on average, through tax benefits.

Hedging to enable greater debt capacity might be beneficial to a firm’s shareholders beyond providing additional value through tax benefits. If additional debt is used to increase the firm’s capital base and provide funds for pursuing valuable investment opportunities, then the added debt capacity reflects value-adding capital. Additionally, firms might benefit from a reduced cost of capital.

Hedging Reflects the Incentives of the Firm’s Management and Board

A firm’s financial risk management strategy may be a function of the incentives and characteristics of its senior management as well as of its board of directors. For example, Smith and Stulz (1985) argue that senior managers who hold significant amounts of wealth in options may have greater incentives to increase, rather than decrease, firm risk because the extra volatility makes the options more valuable. On the other hand, they show that managerial holdings of stock reinforce personal risk aversion, and, therefore, firms in which managers hold more shares of stock will be more likely to hedge. Tufano (1998) extends the model proposed by Froot et al. (1993), and shows that self-interested managers might engage in hedging to avoid the oversight of external capital market providers so that management can consume perquisites at the expense of internal equity providers. The board’s role in risk management has not been modeled explicitly, but the fact that management has incentives to pursue self-interested policies (possibly at the expense of shareholders) suggests that the board might also play an oversight role in a company’s hedging policy.

Other theoretic research, such as Hall and Murphy (2002) and Meulbroeck (2001), suggests that the Smith and Stulz (1985) framework does not account for the interaction of personal risk aversion and lack of diversification. A poorly diversified manager may not recognize the risk-increasing incentives of option compensation. In such a case, option holdings of management would lead to a desire to decrease risk by hedging. In general, the management incentives arguments are silent as to whether hedging adds value.

Tufano (1996) provides evidence that gold price hedging by mining firms is primarily determined by managerial characteristics, including option and stock holdings. Rogers (2002) shows that firms in which CEOs have more risk-taking incentives from options use fewer interest rate and currency derivatives, and finds evidence that these two choices (hedging and risk-taking incentives provided to management) are simultaneously determined.

As opposed to the firm’s senior managers, a vast majority of its directors are unlikely to hold economically significant amounts of stock and/or options in the company on whose board they sit. Nevertheless, the monitoring role of directors suggests that they should have a keen understanding of the firm’s significant risks and how these are being managed.

Borokhovich, Brunarski, Crutchley, and Simkins (2004) hypothesize that a firm with a bigger difference between the number of outsider and insider directors is more likely to be focused on maximizing wealth by effectively managing risk. They test their hypothesis by analyzing the interest rate derivatives usage by large nonfinancial firms in 1995, and find evidence suggesting that outside directors play an important role in the corporate risk management process. Furthermore, if outside directors are effective watchdogs for value maximization, then risk management is likely adding value. A possible extension of this argument is that effective boards will design equity-based compensation contracts that provide senior managers with proper incentives to manage risk.

Does Hedging Affect Firm Value?

Theories of risk management largely pose hedging as a corporate strategy that can increase firm value. Ultimately, the question posed by this section is an empirical one. Interestingly, financial research has not provided extensive direct study of this question. Allayannis and Weston (2001) is the first study to directly analyze the effect of corporate hedging decisions on corporate valuations. They conclude that firms with exposure to foreign currency fluctuations who choose to hedge their exposure with derivatives are, on average, about 5 percent more valuable relative to firms that do not hedge this exposure.

More recently, Carter, Rogers, and Simkins (2006a and 2006b) analyze the jet fuel hedging of U.S. airlines. They argue that an industry-specific sample improves the ability to understand the source of value improvements if these are apparent in the data. They find that median jet fuel hedgers (about 30 percent of the next year’s fuel requirements) are valued approximately 5 percent to 10 percent higher than nonhedging counterparts. They conclude that this hedging premium is a result of the ability to use hedging profits in bad industry cycles to pursue valuable investment opportunities (either by buying assets from financially distressed airlines or by pursuing new routes as distressed competitors retrench).

However, hedging may not add value in all settings. Jin and Jorion (2006) study the hedging decisions of oil and gas producing firms. They show that hedging is not associated with higher firm value across their sample firms. Tufano (1996) concludes that the only factor that drives hedging decisions by gold-mining firms is managerial incentives. Although Tufano did not study the effect of hedging on value explicitly, his results are not particularly supportive that these firms considered value-maximizing rationales in making hedging decisions.

To summarize the key aspects of the discussion, hedging is often a value-maximizing strategy, but only if investors view it as providing tangible benefits. Firms that pursue financial risk management strategies should have clear understandings as to the benefits provided by hedging, and more specifically, if the benefits are economically significant enough to outweigh the costs associated with pursuing an ongoing hedging program.

Credit Risk Management

Credit risk is a potentially large source of risk for many companies. Notably, companies in financial industries often own receivables as their primary earning asset base. But even nonfinancial companies have a significant portion of their assets in receivables. For fiscal 2007 (covering years ending June 2007 through April 2008), the 395 nonfinancial companies in the S&P 500 had $994 billion in receivables on their balance sheets (in total) on aggregate sales of $7,132 billion, so approximately 14 percent of booked revenues reflect uncollected sales dollars.

Sales made on credit reflect short-term lending decisions by firms, and the inability to collect on such sales can have a damaging effect on a firm’s overall profitability if its credit department underestimates the degree to which credit risk might be realized by nonpayment for goods and/or services supplied. To illustrate this with a simple example, suppose a company has $100 million in sales, $14 million in receivables, and its expected net profit margin is 5 percent, so its expected net income is $5 million. If 25 percent of its receivables become uncollectible unexpectedly, the company’s actual net income is only $1.5 million (i.e., net income is $3.5 million less than expected).

In the last two decades, the derivatives market has expanded to include credit derivatives. This market is large and growing. At the end of 2007, the notional amount of credit default swaps was $58 trillion and these contracts were valued at $2 trillion according to the Bank of International Settlements (BIS).⁷ At the end of 2005, credit default swaps in the amount of $14 trillion notional value and $243 billion in market value were outstanding. As such, it might be expected that credit risk management is included in the definition of financial hedging. As a contrast, OTC commodity contracts amount to $9 trillion in notional value (and $753 billion in market value) at the end of 2007. However, Smithson and Mengle (2006) note that nonfinancial corporations have not embraced credit derivatives as a hedging tool. He states that recent data from the British Bankers Association shows only 2 percent of credit protection buyers are nonfinancial corporations.

The major interaction between financial hedging and credit risk management stems mostly from the fact that many hedging strategies are used to manage the currency and/or commodity price risks associated with anticipated transactions. If the anticipated transactions are expected future sales, then the financial risk (i.e., currency and/or commodity risk) is typically recognized before the firm recognizes its credit risk to its customer (because the credit risk is initiated when the credit sale is actually recognized for accounting purposes). By managing financial risk in advance of credit risk, the firm is better able to manage its expected profit on future transactions, while credit risk management is used to ensure realization of the profit. Given the relative underutilization of credit derivatives by nonfinancial corporations, it appears that most companies employ other techniques to manage the risk of nonpayment by customers.

Operational Risk Management

A firm’s operating choices expose it to many risks. A fundamental theory of financial economics is that a firm’s investment choices reflect positive net present value (NPV) opportunities on a risk-adjusted basis. In other words, a company invests in risky assets in which it believes its people have the necessary expertise and knowledge to create value from these assets. The firm’s operational risk management⁸ strategy includes actions that reduce the risks associated with its operating choices.

Financial risk is often embedded in a company’s operating choices. For example, a manufacturing firm faces choices as to where to locate its manufacturing facilities. Suppose the company chooses to build its manufacturing facility in a country with low labor costs, but the product is exported to other markets globally. The firm has exposed itself to currency risk, and this can be managed by using currency derivatives (i.e., a financial hedge). Suppose, on the other hand, that the manufacturing location is chosen based on its superior access to the ultimate markets in which the product is sold. In this case, the currency risk may be less than in the first case (but it still exists).

The choice of manufacturing location is an operating decision that changes the firm’s risk profile depending on the choice of parameters used. From finance theory, the location with the highest expected value on a risk-adjusted basis is chosen, and this reflects the operating risk management decision. Financial risk management can be employed on a flexible basis to offset any hedgeable risks that are explicit functions of the company’s operational risk management choice.

The company may periodically reevaluate its operating choices (i.e., consider selling an existing plant and buying or building a plant in another location). For example, the current weak U.S. dollar has created conditions under which U.S.-based companies with foreign manufacturing operations chosen previously because of lower costs relative to manufacturing domestically are considering moving some manufacturing capabilities to the U.S. As a recent example, FEI Corporation announced in its April 29, 2008, earnings release that it plans to transfer supply chain and manufacturing operations to “lower-cost alternatives that are primarily dollar-based.”⁹

Strategic Risk Management

Strategic risk reflects the opportunities and threats faced by the firm given its competitive environment. Obviously, this type of risk is of paramount importance to businesses. Financial risk clearly constitutes risks that are not part of strategic risk. Nevertheless, financial risk management may assist firms in taking advantage of certain types of strategic risks.

One of the noted benefits of financial hedging is its ability to reduce underinvestment problems. An inability to capitalize on all valuable investment opportunities represents one source of strategic risk. Thus, financial risk management provides a potential avenue for firms to make value-enhancing investments during periods in which they might otherwise be unable to do so.

An excellent example of this type of interaction has occurred in the U.S. airline industry. Southwest Airlines has been, by far, the most active hedger of financial risk occurring from the uncertainty of future jet fuel prices. During this time frame, the company has grown considerably while other airlines have been forced to retrench. In a July 1, 2008, Associated Press article on jet fuel hedging in the airline industry, S&P airline analyst, Betsy Snyder, is quoted, “This (Southwest Airlines) is a company that has always taken advantage of others’ misfortune.”¹⁰ The cash flows realized from its active program of hedging anticipated jet fuel costs have been instrumental in pursuing this strategy.

Reputation and Legal Risk Management

A company’s failures in managing financial risk can affect its reputation and even its existence. In the mid-1990s, several high-profile cases of big risk management failures occurred. Chance and Brooks (2007) highlight the hedging debacles of Metallgesellschaft AG in 1993 ($1.3 billion lost on crude oil, heating oil, and gasoline futures contracts), Orange County, California, in 1994 ($1.6 billion lost on leveraged repurchase agreements), and Barings PLC in 1995 ($1.2 billion on stock index futures and options). These cases (as well as numerous other derivative losses shown on pages 572–573 of Chance and Brooks 2007) are worth noting for all users of derivatives because of the risk of business failure that can occur if derivatives are used improperly. Additionally, poorly devised financial hedging strategies could conceivably make a firm susceptible to legal actions filed by unhappy shareholders.

On the other hand, some firms have been held up as role models for successful financial hedging. Carter, Rogers, and Simkins (2006b) note that Southwest Airlines has realized significant cash flows from its jet fuel hedging strategies and that these cash flows are instrumental in helping the company take advantage of growth opportunities. Merck’s currency hedging strategy has served to protect its ability to fund valuable research and development (R&D) spending, and is frequently cited by academics (for an example, see “University of Georgia Roundtable on Enterprise-Wide Risk Management” 2003).

Financial Reporting and Disclosure Risk Management

Financial hedging has caused additional financial reporting requirements associated with using derivative financial instruments. In 2000, the U.S.-based accounting standards setter, the Financial Accounting Standards Board (FASB), implemented FAS 133, which sets the U.S. GAAP rules with respect to accounting for derivatives. Prior to the adoption of FAS 133, firms using derivatives were merely required to provide disclosures in financial statement footnotes about fair values of derivative contracts held at the end of the reporting period, notional value of these derivatives, and some additional qualitative disclosure regarding the strategies employed for using derivatives (including the firm’s purpose). With the advent of FAS 133, market values of derivative contracts are now required to be disclosed as assets or liabilities, reflecting whether the contract is in a receivable or payable position. The fundamental accounting treatment of derivatives under FAS 133 is similar to those required under international accounting rules (i.e., IAS 39).

The most significant aspect of FAS 133 is the fact that firms must qualify their derivative contracts as being eligible for “hedge accounting.” If a derivative transaction qualifies for hedge accounting, then the derivative contract does not affect earnings until a realized gain or loss occurs. However, if a derivative transaction does not qualify for hedge accounting treatment, then unrealized market value changes in derivative contracts are required to be reflected in a firm’s earnings.

If accounting regulations make qualification for hedge accounting difficult, financial hedging might add volatility to a company’s reported earnings. If investors do not understand the requirements for hedge accounting (entirely possibly given that FAS 133 is widely considered the most complicated accounting standard ever written by FASB), it is quite feasible that firms employing economically meaningful financial hedging strategies could exhibit more volatile net income over time because of the effects of unrealized derivative gains and losses that are included in income.

As an example of how the accounting regulations can create more volatility in reported income, Southwest Airlines disclosed in its 2007 10-K filing that, in 2006, the company recognized $101 million in nonoperating losses because of its inability to qualify its fuel hedges for hedge accounting under FAS 133.¹¹ On the other hand, Southwest recognized $110 million of nonoperating gains during 2005 for the same reason. By creating the potential for periodic shifts between nonoperating gains and losses associated with unrealized derivative value changes, FAS 133 creates an environment in which hedging firms may exhibit more volatility in net income than nonhedgers.