In the current uncertain economic environment, many companies may wish that they had increased their hedging activity to mitigate the current impact. It is often much easier to appreciate the value of hedging when a crisis comes in hindsight. Rather than succumbing to sensationalism, in this article we will take a look at scientific evidence examining whether hedging creates any value.

    Does hedging improve shareholder value?

    In short, yes. There is some strong evidence that hedging does seem to improve shareholder value, particularly when looked at over a longer term horizon.

    This value creation does not come from timing hedging activities “correctly.” The value creation comes from improved perception of stability by investors. In addition, the ability to continuously fund business investments unhindered by market volatility can be shown to improve shareholder value.

    In other words, trading acumen matters a lot less than correctly identifying risks and taking positive measures against them.

    As we shall see in this article, there is quite a large volume of academic literature that support this notion. We will also include an analysis conducted by ourselves on the China Property sector that provides further support to the proposition that minimizing unhedged exposures is correlated with higher equity valuations, keeping everything else constant.

    Academic papers say yes

    As corporate risk management professionals (and likely anyone reading this article), we inherently believe that there is value in practicing good risk management. Does the academic literature support this seemingly obvious belief? Thankfully for our professional existential psyche, the evidence shows that risk management is a value-add endeavour. We focus on four academic papers below.

    Back in 1994, Froot et al established that proper risk management commands a higher premium because firms would not have to cut investment plans due to external shocks (a.k.a. “underinvestment friction”). This improves the overall probability-weighted future cash flows and hence company valuation.

    A Framework for Risk Management (1994), Froot, Scharfstein, & Stein
    • Froot et al posit that the role of risk management is to ensure that a company has the cash available to make value-enhancing investments.
    • Firms create value by making good investments and, due to the perceived high costs of external financing, firms generally make these investments through internally generated funds.
    • Firms typically cut investment spending when they don’t have the internally generated cash flow to finance all their investment projects - indeed, one study referenced found that companies reduced their capital expenditures by roughly 35 cents for each USD1 reduction in cash flow.
    • Risk management enables companies to become better at aligning the demand for funds with the internal supply of funds, which creates value for the firm.

     

    In 2008, a paper looking at the 1999 Brazilian currency crisis, found that Brazilian firms who hedged had valuations that are 7 per cent higher than non-hedging firms.

    Corporate Hedging, Investment and Value (2008), Berrospide, Purnanandam, & Rajan
    • In 2008, Berrospide et al consider the effect of hedging with foreign currency derivatives on Brazilian firms in the period 1997 through 2004, a period that includes the Brazilian currency crisis of 1999.
    • The paper finds that derivative users have valuations that are 6.7–7.8 per cent higher than non-hedging firms.
    • Hedging with currency derivatives allows firms to sustain larger capital investments and also removes the sensitivity of investment to internally generated funds.
    • Thus, it mitigates the underinvestment friction of Froot et al (1994), at a time when capital in the economy as a whole is scarce.

     

    In 2017, after crude oil volatility seen in the past decade, a paper looking at key input price volatility for shipping companies found that higher fuel prices led to reduced capex by these companies, hurting long term value. Those companies who hedged fuel costs also had lower business volatilities and higher return on invested capital.

    Does hedging increase firm performance? (2017), Nilsson & Arévalo
    • The paper analyses the hedging activity of shipping companies headquartered in Europe and North America and its impact on Return on Invested Capital (ROIC).
    • Regarding the interaction between investing and fuel costs and its effect on ROIC the paper found that fuel prices are negatively related to capital expenditures.
    • Acting as another example of risk management mitigating underinvestment friction, shipping firms that engaged in fuel hedging were able to sustain higher capital expenditures and the higher capital spending contributed positively to ROIC.
    • Additionally, fuel cost hedgers had lower operating cash flow volatility and EBIT margin volatility.

     

    Also in 2017, another paper looked at output price volatility, and similarly found that large companies tend to have more sophisticated hedging strategies for their revenues and can better protect their capex requirements than smaller companies.

    Uncertainty, Capital Investment, and Risk Management (2017), Doshi, Kumar, & Yerramilli
    • Doshi et al explore the effects of price uncertainty on firms’ hedging activity and capital investment.
    • The negative effect of uncertainty on capital investment is significantly weaker for firms that hedge their output price risk.
    • When faced with high price uncertainty, large firms increase their hedging intensity but do not lower capital investment or debt issuance.
    • In contrast, small firms do not adjust their hedging intensity but significantly lower capital expenditure and debt issuance even after controlling for investment demand.
    • In other words, hedging firms are able to mitigate underinvestment friction and are better positioned to make value-enhancing capital investments.

     

    In summary, we find that academic literature supports our belief in the value creation of corporate risk management activities, whether the risk exposures arise from the balance sheet, or from the business (i.e. input or output price risks). This is achieved through mitigating underinvestment friction and allowing corporates to make value-enhancing investments even during times of market uncertainty.

    We found a positive correlation between the proportion of foreign currency debt left unhedged and equity beta. This is further evidence that positive risk management actions can potentially reduce cost of equity and hence higher firm valuation.

    Our analysis on the China Property sector

    The China property sector provides another excellent case study to analyse the effect of risk management. Most companies in the sector borrow externally in USD or HKD, against their functional currency which is RMB. Many of them are also listed in offshore exchanges such as Hong Kong or Singapore.

    Our analysis suggests that, after leverage, the key determinant of equity risk premium for China property companies would be currency risk. Whilst they could perhaps only do little to influence the currency risk arising from the translation of the whole business which are principally in onshore China, companies can take steps to reduce their foreign currency debt proportion in the short term using derivatives.

    We found a positive correlation between the proportion of foreign currency debt left unhedged and equity beta. This is further evidence that positive risk management actions can potentially reduce cost of equity and hence higher firm valuation.

    We have considered 28 China property companies that are listed in Hong Kong or Singapore, looking at the share price performances from the calendar years of 2015 to 2019.
    • After controlling for the effect of leverage, we find that the “equity betas” of companies can be explained by their “currency betas” with an R-squared of 97 per cent, indicating a strong influence of currency risks to equity risk premium.
    • We calculated the “equity beta” and “currency beta” for each company, by comparing their share price volatility versus the benchmark volatility.
    • Equity beta is a key determinant of a company’s cost of equity and firm valuation.
    • We found that high-beta companies tend to have larger ratios of unhedged foreign currency debt (i.e. 37 per cent unhedged), and this is compared with low-beta companies which are only 16 per cent unhedged. Meanwhile, medium-beta companies are 31 per cent unhedged.

     


    Source: HSBC Thought Leadership

    Key Takeaways for CFOs and Treasurers

    When it comes to risk management, it is easy for companies to focus too much on individual hedging outcomes and miss the big picture.

    As we have seen throughout this article, there is comfort to offer companies. Companies don’t have to “win” every single hedge to win the biggest prize which is firm stability and ability to consistently grow the business ultimately leading to a higher firm valuation.

    Athletes do not prepare for a marathon by training with 100 metre sprints. They prepare by developing a process that suits their body type and running style and structure the environment so that they could deliver the process consistently.

    Companies equating the value of their hedging programmes to the P&L outcomes of their hedges are like long distance athletes obsessing over their 100 metre sprint times.

    The more important aspect to concentrate on is whether a systematic process is in place that can improve the overall firm’s risk profile as perceived by investors and creditors.

    As we illustrated above, the systematic approach will create smooth outcomes and create shareholder value.

    Reference:

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