Question 1 CRP is required by the banks to hedge its interest rate exposure for a minimum amount and period. Which of the hedging instruments would you advise CRP to choose and why? (50 marks)
At normal interest rate, Expected probability of risk is 0.87x0.5=0.435
At higher interest rate, expected probability of risk is 1.385x0.25=0.34625
At lower interest rate, expected probability of risk is 1.1175x0.25=0.2794
The probability of the risk occurring is lower at the lower interest rating therefore the company should take the option at lower interest rate. The scenario with the lower interest should therefore be taken into consideration because it is associated with lower risks.
Hedging instruments are essential in financial markets in order to protect the financial assets from volatility of prices especially of those inputs, which are beyond the control of the organization or company.
These items or instruments are essential in the prediction of risks and outcomes of the risky ventures. It is therefore an obligation of a company to analyze various prices of production inputs like oil because it greatly influences price fluctuations in the economy. Price fluctuations and interest rates are crucial tools in formulation of hedging policies.
The probabilities for each interest level are computed in order to determine the sum of probabilities in the hedging techniques. Interest rates for each level or period are necessary in order to predict the future prices of the financial assets depending on the prevailing market forces. The combination of asset portfolios is also evaluated in order to determine their overall effect in price predictions and estimations.
Question 2 Should CRP hedge the full amount of the loan for full period? Why or why not? (25 Marks)
For the CRP Company, the hedges considered in a way are perfect. Andre is able to specify a future date when the company’s products are in a position to be sold or bought. He is in a position to eliminate if not all the risks some conditional risks of hedging arising from economic dynamics including the rising prices and rating of assets.
However, the solid truth is that hedging is not that simple and predictable. Hedging contracts are not straight forward as Andre strategy seems to ascertain. Hedging can only reduce risks to possible lower levels and it cannot have the capacity to eliminate the all the risks as the external environment including the legal requirements are still critical in application of hedging as a financial risk minimization strategy.
The losses that might be met during the selling of an asset may not always be the same as profits obtainable from taking other future positions including hedging for the sake of CRP. This is usually because of the difference affected by the future value consideration of money. The value of Company’s asset sold at spot market price will not be of the same value as of the same asset sold at underlying future contract.
Hedging the whole amount of loan for the whole period of time is detrimental to the company in that the future costs of the loan interest are higher than the present payment. The hedging of the loan and its successful repayment is a matter of uncertainty and thus there exists a possibility of imperfect hedge as policy and economic changes may render the period estimated for well closure of the hedge to be arbitrary and expiration will catch up with the Company.
The company by hedging the full loan will anticipate for successful termination may lead the company to rollover. The expiration of the may be altered from the anticipated to later dates than the delivery dates. When this occurs, the company may have to be effect by closing up the futures contracts and may be take positions for future contracts that have the same future delivery dates. These rollovers can be rolled repeatedly for several years. However, many rollovers may put the CRP Company into short-term cash flow problems.
It is therefore, advisable for CRP Company to avoid hedging the whole loan for the whole period in order to avoid severe short-term cash flow issues that may prevail. The CRP Company should instead hedge half of the loan for half of the period. This will not put the Company into many risks including destabilizing the Company’s cash flow, liquidity and solvency. By avoiding hedging full loan, the company will reduce the effects of volumetric risks that may result from the company’s products being less demanded during the period of the contract.
The company at this state will not be in a position to meet its obligations and thus ending facing financial constraints and complications. Volatility risks, these are risks associated with money markets. The money market is one of the most influential sectors in the world economy therefore; its dynamism is detrimental to hedging contracts. Full hedging of the Company loan might be problematic if financial rates increase.
The company will be forced to pay in excess of anticipated payments. Equity risks, these are risks attached to investments depreciation. The CRP Company is risking losing investments effected by the loan in times of changes in the stock market a rising from unforeseen circumstances like inflation. The Company should strive to repay its loan as early as possible for the sake of avoiding these possibilities, as the future is not guaranteed. The Company will in the struggle to pay the loan make effective efforts to increase its capacity and make recommendable profits.
For the sake of collars the Company should consider the fact that, though hedging with collars is pay a minimum bid-ask spread. Since swapping of cash for collar does not exist then the loan payments will always be embedded on the two arms of the collar. In specification, the value of call option that is assumed by the Company will always be higher than the value of bought protection.
Question 3 is it possible to create shareholder value through hedging. Is shareholder value a realizable project or a myth in a financialized economy? (25 marks)
Hedging as has been defined is making an investment so as to take a risk for another investment. This hedge acts as a cushion for the main investment. I say it is possible to create shareholder value through hedging. This would involve understanding the level of the risk to be undertaken first as well as keeping the objectives of the main investment first. The best hedging strategy does not always want to eliminate all the risk in the particular investment. Instead, the objective is to find a hedging strategy that will balance the risk the company is willing to bear with the best interests of the company, which is to make profits.
In the corporate, it is possible to create shareholder value through hedging. This is seen when capital markets are imperfect and there are indirect costs experienced or there is financial distress. This allows the hedge investments value to increase. When external financing becomes costly and taxes increase, hedging process is able to create shareholder values.
It is very possible to create shareholder value through hedging. This will mean that the hedging program is earning profit of which it can sustain itself. For instance, if there are two companies producing the same product though one produces a more quality product, one can make investments on both companies and the investment on the ‘inferior’ company will act as the hedge to the investment on the first company?
The amount of profits that are earned from the investment on the company whose product is of inferior quality can be used to make purchases for the shares for the same company. The shares bought by the hedging investment will now cover the risk of the company. This investments will most of the time depend on the level of the interest rate. With high interest rates, the chances of investing the hedging funds will reduce with the increasing rates of interest rates.
In the present world, most of the time it is always next to impossible to achieve this project of creating shareholder value with the hedging funds. This is because the interest rates in the money market keep on changing and are rarely constant. This makes it very difficult to evaluate future estimates, which are most of the time very important in deciding whether to make purchases of the shares, or not. In the financialized economy, most companies result to trading in the stock exchanges rather than trading in the traditional industrial economy or maybe agricultural economy.
As the companies, increasingly become more resolute and expand in their businesses, the level of risks to be taken for a particular company become very complicated. The interest rates, exchange rates and other market factors make the deciding of hedging programs a challenging and delicate matter.
The competitions in the money market also present a serious challenge to realizing the project on creating shareholder values for the hedging strategies. It becomes a myth since with the share prices being very unpredictable due to the increasing competitions; one would not like to invest his hedging fund in shareholder values since these funds are the ones supposed to cushion the company in case of crises.
Using the example above on using the shares of an ‘inferior’ company, in the product loses its taste in the goods and it loses its preference in the customer’s basket of goods, the company will lose both its shares and as well as the funds used in the hedging process. Most of the companies always will not want to undertake this risk of losing both the company’s investments as well as the hedging investments.
In most times, hedging increases shareholder value when there are market imperfections, which allow the value of the hedge funds to increase in value. This is not always seen in the present world. The present managers have taken caution in making sure that they take care of these market imperfections by creating good risk-management teams, which help in creating decisions that see the market remain constant. This presents a hard scenario for creating shareholder values. With most governments stabilizing taxes and external financing reducing in most companies, it is hard for companies to create shareholder value by hedging.
Bowen, E. (2007). The Euromoney foreign exchange & treasury management handbook 2006. Colchester, Essex: Adrian Hornbrook.
Cooper, R. (2004). Corporate treasury and cash management. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.