How do firms manage financial risk? Not by hedging everything they can. A manufacturer that sells abroad, borrows at floating rates and buys metal on the open market faces three financial risks before it makes a single product, and for each one it has to decide whether to keep the risk, cut it, avoid it or pay someone else to carry it. A wrong answer can make the hedging program itself the biggest threat to the firm.
The previous chapter set out why risk management matters. This one, the second in FRM Part 1, turns to how a company actually does it: the case for and against hedging, how a risk appetite is set and put into operation, how exposures are mapped, how a strategy is chosen and a risk team sized, which limits and instruments are used, and what has gone wrong when hedging programs failed. The worked examples use the main hedging strategies for currency, commodity and interest rate risk.
Key Takeaways
- Firms manage financial risk by choosing, for each exposure, whether to retain, avoid, mitigate or transfer it, guided by a board-approved risk appetite rather than a rule to hedge everything.
- Risk appetite is the risk a firm is willing to bear; risk capacity is the most it could bear without failing; the risk profile is what it bears today, and a healthy firm keeps profile below appetite and appetite well below capacity.
- Hedging reduces the costs of financial distress, reassures creditors and makes planning possible, but it has transparent and hidden costs and adds little for diversified shareholders.
- Hedging strategies use forwards, futures, swaps and options, trading off price certainty against flexibility and exchange liquidity against tailored OTC fit and its counterparty risk.
- Risk mapping nets offsetting cash flows into natural hedges first, so derivatives cover only the exposure that remains.
- Each risk limit has a blind spot, so firms layer stop-loss, notional, Greek, VaR and stress limits, and judge every hedge on its cash needs as well as its value.
Why Firms Manage Financial Risk Today
Firms have always managed their core business risks. They study what drives customer demand, line up more than one supplier for critical parts, back up their data and insure their warehouses. Financial risk, meaning exposure to commodity prices, interest rates, exchange rates and credit, was not always handled with the same care. Two forces changed that, and GARP describes them as need and opportunity.
- Need. From the 1970s, markets for commodities, interest rates, credit and foreign exchange were liberalized, price volatility rose sharply, and the global economy expanded. A firm that once faced stable prices now faced prices that could move a long way in a year.
- Opportunity. The volatility itself created a fast-growing set of risk management instruments in the 1980s and 1990s, helped by advances such as the Black-Scholes-Merton option pricing model and securitization. Credit and weather derivatives followed in the 1990s, and cyber risk transfer products in the twenty-first century.
Growth in the largest derivatives markets has since leveled off in some categories, as speculative use declined, bank regulation tightened and interest rates and volatility fell after the 2007 to 2009 crisis. Other risk transfer markets, such as cyber, are still growing quickly.
When a hedge stops being a hedge
The same instruments that let a firm hedge an exposure can also change its whole risk profile within hours, and the change may not be obvious. Consider a company with floating-rate debt that buys a structured product which caps its interest cost as long as rates stay inside a band, but which makes its exposure larger if rates break through the top of the band. Inside the band the product reduces risk; outside it, the company is holding a bet. With a computer, the right passwords and board approval, an ordinary manufacturer can carry a risk profile once associated only with investment banks. Much of the investment in corporate risk management exists to make sure that capability is used wisely.
Before a firm hedges anything, it has to answer three questions: does managing this risk make sense for the firm’s owners, what exactly is the strategy meant to achieve, and how much risk should the firm keep? Wrong answers can turn risk management itself into a major threat to the firm.
The Road Map: Five Milestones
GARP sets out the corporate risk management process as a road map with five milestones. The chapter follows them in order, but the process is iterative. Once a firm understands how much it costs and how complex it is to manage the risks of one business unit, it may go back and ask whether it should be in that business at all.
Should a Firm Hedge at All?
Just because a risk can be hedged does not mean it should be. Hedging is a tool with limits. It can stabilize earnings only over a fairly short horizon of a few years, and it has costs of two kinds: transparent ones, such as an option premium, and opaque ones, such as the danger of a tactical error or a rogue trader inside the hedging program.
The deepest objection comes from finance theory, and it turns on who owns the firm. An investor who holds a stock as one of many in a diversified portfolio has already diversified away the risks specific to that firm, so reducing them adds little value for that investor. The systematic risks that diversification cannot remove, such as interest rate risk, can be managed by the investor at the portfolio level. Some investors even buy a stock precisely for its exposure to a macroeconomic variable, such as the price of gold, and would not thank management for hedging it away. The answer changes when the owner is concentrated in one firm, as with a family-owned or state-owned company; that owner bears the firm-specific risk directly and generally does want it managed.
Decades of empirical studies have tried to show whether hedgers are worth more than non-hedgers, and none has delivered a decisive verdict either way. The answer may differ by industry.
A pension fund holds shares in 2,000 companies, including a mid-sized gold miner. The miner’s managers propose hedging all of its gold price exposure. Why might the pension fund object, and when would a shareholder take the opposite view?
Show answer
The pension fund is diversified, so the miner’s firm-specific risks are already largely diversified away in its portfolio, and it can manage broad risks such as interest rates itself. It may also hold the miner precisely for its exposure to gold, which a full hedge would remove. A shareholder with most of their wealth in this one miner, such as a founding family, bears its risk directly and would generally want it managed.
The Real-World Case for Hedging
The theoretical argument against hedging assumes markets that are, in some sense, perfect and frictionless. Real markets are not, and the imperfections give hedging its value.
- Financial distress is expensive. Distress carries direct costs, such as bankruptcy costs, and large opportunity costs. A firm hit by an unexpected market loss cuts investment elsewhere and becomes cautious, and hedging reduces the chance of reaching that point.
- Creditors, customers and suppliers want stability. A lender gets none of the upside from a firm’s revenue swings and cares only whether the firm can keep its promises. Key customers and suppliers feel the same way.
- Hedging can raise cash flows. A firm that can offer customers a fixed price for three years may win business it would otherwise lose, but it may only be able to make that offer if it hedges a key input. A firm that agrees to deliver into a foreign market next year must hedge the currency to lock in its margin.
- Planning becomes possible. For managers this may be the most important operational benefit. Without a hedge, a currency that can move 15 percent in a year makes a reliable budget almost impossible.
Northbank Machinery, a US manufacturer, signs a contract to deliver equipment to a German buyer in 12 months for EUR 10 million. Its dollar costs for the order are USD 9.6 million. The spot rate is USD 1.10 per euro and a bank offers a 12-month forward rate of USD 1.08. Compare the margin if Northbank sells the euros forward with the margin if it waits and the euro falls to USD 0.98.
Step 1. Hedged revenue at the forward rate.
Step 2. Hedged margin.
Step 3. Unhedged revenue and margin if the euro falls to USD 0.98.
Answer: the forward locks in a margin of USD 1.2 million, about 11 percent of the dollar revenue (1.2 / 10.8), whatever the euro does. Left unhedged, a fall in the euro to USD 0.98 cuts the margin to USD 0.2 million, and a slightly bigger fall would turn the order into a loss. The hedge does not make Northbank richer on average; it makes the order a known quantity that the firm can price and plan around.
Equity investors are also not the only stakeholders, nor the only decision makers. Managers, regulators and staff all expect the firm to be sound and protected from sudden mishaps, but managers may also be tempted to use hedging to hit short-term targets, such as analyst forecasts, that affect their pay and reputation. Derivatives can amplify these agency risks, and risk managers need to watch for them. A firm should be able to state why it hedges, in terms of its basic aim (managing accounting risk, balance sheet risk, economic risk or operational risk), and how much risk it is willing to bear.
The case against hedging is about investors, who can diversify on their own. The case for hedging is about the firm, which cannot diversify away its own distress costs, its creditors’ concerns or its need to plan. Which side wins depends on how concentrated the owners are and how costly distress would be for this particular firm.
Risk Appetite, Risk Capacity and Risk Profile
Risk appetite is the amount and type of risk a firm is willing to accept in pursuit of its goals. It is different from risk capacity, the maximum amount of risk the firm can absorb before it fails or breaches a binding constraint. For a bank, the regulatory minimum leverage ratio marks one hard edge of capacity. The amount of risk the firm actually carries today is its risk profile.
A growing number of companies use a board-approved risk appetite to guide management, and some summarize it for investors in their annual reports. In practical terms, a risk appetite is two things:
- A statement of the firm’s willingness to take risk in pursuit of its business goals. The detailed version is usually an internal document approved by the board.
- The mechanisms that link that statement to day-to-day risk management: the detailed risk policy, risk statements for each business, and the framework of limits for key risk areas. These should also be approved by the board, and they must be consistent with the other signals the firm sends staff about risk, above all its incentive pay.
The term is used loosely in business writing, so it helps to fix its meaning. Risk appetite is not the most risk the firm could bear, and it is not the risk it happens to carry today. It is the amount of risk the firm is willing to bear at any one time, which sits below capacity and above the current profile. Firms often add trigger points just below the appetite, so the board hears early if risk taking is drifting toward the limit, and also if it looks unusually low.
Risk appetite is also part of a firm’s identity. A biotechnology company may stake most of its capital on one drug trial, because that bet is the reason the company exists and the area where its expertise lies; for that firm, taking the bet is risk management. The same company can sensibly refuse to carry any currency or interest rate risk at all. Appetite should be judged risk type by risk type, according to where the firm has real expertise, rather than labeling the whole firm “conservative” or “entrepreneurial”. Before trying to put an appetite into operation, a firm has to ask who it is, and who its stakeholders think it is.
A firm’s own risk appetite is a fairly stable, through-the-cycle attitude. It differs from the “risk appetite” economists measure across an industry by surveying executives, which is a point-in-time reading of sentiment that moves with the economy and with events.
Turning a top-level appetite statement into operating limits is difficult, because, as the first chapter showed, no single risk measure can be monitored at the business level and then simply added up across the firm. Firms therefore operationalize appetite with several measures at once: notional limits for particular businesses and risks, unexpected loss estimates, versions of value at risk and stress tests, with the level of detail matched to the risk and to how sophisticated the strategy is.
Keep the three terms in order. Capacity is the most risk the firm could bear without becoming insolvent. Appetite is the risk it is willing to bear. Profile is the risk it bears today. A healthy firm has profile below appetite and appetite well below capacity.
A bank estimates that it could absorb losses of USD 5 billion before breaching its minimum capital requirement. Its board has agreed it is willing to put USD 3 billion of capital at risk, and the bank’s current positions consume USD 2.4 billion. Label each figure and state the headroom.
Show answer
USD 5 billion is the risk capacity, USD 3 billion is the risk appetite and USD 2.4 billion is the current risk profile.
The bank can add USD 0.6 billion of risk before reaching its appetite, and it keeps a buffer of 5.0 − 3.0 = USD 2.0 billion between appetite and capacity.
Risk Mapping and Natural Hedges
The appetite statement says what the firm is trying to achieve. Risk mapping works out what the firm is actually exposed to, at the level of cash flows, and how large and how soon each exposure is. For a commodity risk, a manufacturer that uses copper would start with how much copper it will need, when and where it needs it delivered, and which local price benchmark best represents what it will pay. For currency risk, the first step is to list existing positions, contracts and expected transactions, then decide which ones the hedging policy covers (for example, whether sales that are probable but not yet certain count), and when each cash flow falls.
Mapping often reveals that some cash flows offset each other, by design or by accident. Those natural hedges cost nothing, and a good map shows the firm both where they exist and how to create more of them in future. Large international firms often hedge most of their exposure this way, through their business decisions, and use derivatives only to fine-tune what is left.
Saraswati Textiles, a UK company, maps its euro cash flows for the next six months. It expects EUR 18 million of sales receipts from European customers, and it will pay EUR 7 million to a German machinery supplier and EUR 4 million in salaries at its office in Spain. How much euro exposure does it actually need to hedge?
Step 1. Total the euro payments.
Step 2. Net them against the euro receipts.
Answer: the net exposure is EUR 7 million, not EUR 18 million. Hedging the gross receipts would have hedged EUR 11 million that was already protected by the firm’s own euro payments, which would have created a new exposure rather than removed one. The map shows the firm needs to sell only EUR 7 million forward, and the timing of the flows tells it how to date the hedges.
Mapping must not stop at risks that are easy to express as cash flows. A firm also faces risks it will need to insure, such as natural catastrophes, physical accidents and cyber incidents, and a new business line may bring hard-to-quantify data privacy risk alongside its obvious currency exposure.
Choosing a Strategy: Retain, Avoid, Mitigate or Transfer
With the appetite set and the risks mapped, the risk manager can decide how to handle each one. The first step is to prioritize: which exposures are most severe and most urgent? The second is to weigh the costs and benefits of the four basic strategies, summarized in Exhibit 1.
| Strategy | When it fits | Example |
|---|---|---|
| Retain | The risk is natural to the business, investors want it, or it behaves like an expected loss that can be priced in. Retained risks are not necessarily small. | A copper miner keeps its copper price exposure because its shareholders buy the stock for exactly that exposure |
| Avoid | The risk is “unnatural” to the business and can only be removed by stopping an activity | A software firm closes a trading desk that was speculating on currencies |
| Mitigate | Exposure, frequency or severity can be reduced at a reasonable cost | A delivery company replaces its fleet with more fuel-efficient trucks to cut its fuel price exposure |
| Transfer | A third party will take the risk for a price, through insurance, derivatives or securitization | A utility buys an interest rate cap on its floating-rate debt |
A firm that says it has “zero tolerance” for some risk, or some kind of behavior, is only describing its hopes unless the safeguards to enforce that tolerance are in place. Senior management and the board choose strategies for the large risks, and the risk manager’s job is to help them find the option that keeps the firm within its appetite at the least cost.
The costs are rarely fully visible. The true cost of transferring a risk includes the cost of the people who manage the hedge and of the risk left over, such as basis risk. Some costs cannot be priced at all: a firm that hedges a commodity price gives up the short-term advantage its unhedged rivals gain if the spot price falls. Numbers are essential, but so is business judgment, especially for risks that are harder to quantify than market risk.
Kaveri Payments estimates, from worst-case analysis and expert judgment, a 4 percent chance next year of a data breach costing USD 50 million. A systems upgrade costing USD 1.2 million a year would cut the chance to 1 percent. A cyber insurance policy costing USD 1.5 million a year would cover the loss above a USD 10 million deductible. Compare the expected annual cost of each choice.
Step 1. Retain: the expected loss with no action.
Step 2. Mitigate: the upgrade cost plus the smaller expected loss.
Step 3. Transfer: the premium plus the expected loss the firm still bears up to the deductible.
Answer: on expected cost alone, mitigating is cheapest at USD 1.7 million a year, against USD 1.9 million to insure and USD 2.0 million to retain. Expected cost is not the whole story, though. Retaining leaves a 4 percent chance of a USD 50 million hit, and the insurance caps the worst case at USD 10 million. A firm with little appetite for a large single loss might combine the upgrade with a policy, which is why the decision belongs with the risk appetite and not only with the arithmetic.
Name the strategy: (a) a coffee chain prices its expected rise in bean costs into next year’s menu; (b) an airline buys newer aircraft that burn 20 percent less fuel; (c) a bank sells a portfolio of loans into a securitization; (d) a manufacturer shuts a division that traded commodities for profit.
Show answer
(a) Retain: the cost behaves like an expected loss and is priced into the product. (b) Mitigate: lower fuel burn reduces the exposure without removing it. (c) Transfer: the credit risk passes to the securitization’s investors. (d) Avoid: the firm removes a risk that is unnatural to its business by stopping the activity.
Rightsizing the Risk Management Function
Once the goals are set, the firm needs a risk function able to deliver them, and its size has to match the strategy. Transferring a well-understood risk with a one-off hedge or an annual insurance policy is fairly straightforward. Running a dynamic hedging strategy that is adjusted continuously in the markets is a different undertaking. Dynamic strategies can save money, but they need far more investment in systems and trading expertise, more complex models and metrics such as VaR, a wider limit system, and a clearer separation between the people who trade and the people who record and oversee the trades.
A firm that uses sophisticated instruments without the in-house expertise to match can become dependent on its suppliers, usually investment banks, and may end up unable even to price its own positions independently. Several times a year, the board should check that the firm’s level of sophistication matches how conservative its strategy is meant to be.
The firm must also decide whether risk management is a cost center or a profit center. At most non-financial firms it is a cost center; some risk management activities at banks are run for profit. A related choice is whether to charge the cost of risk management back to the businesses it serves. The answers depend on the firm’s risk culture and appetite. Making the function fit for purpose comes down to a short list: an agreed hedging philosophy and goals, a clear accounting treatment, defined risk types and time horizons, enough resources and budget, independent reporting lines with oversight, documented policies and procedures, and a way to evaluate performance that does not reward the wrong behavior.
Risk Limits and What Each One Misses
Limits are how a risk appetite reaches the trading desk. No single limit captures everything, so firms layer several types, each of which closes one gap and leaves another open. Exhibit 2 sets out the main types.
| Limit | What it caps | Weakness |
|---|---|---|
| Stop-loss | A loss threshold that triggers an action, such as closing the position or escalating | Acts only after losses are realized; does not prevent new exposure |
| Notional | The notional size of an exposure | Notional may bear little relation to the economic risk of a derivative, especially an option |
| Risk-specific | A feature of one risk, such as a liquidity ratio | Hard to aggregate; needs specialist knowledge to interpret |
| Maturity or gap | The volume of transactions maturing or repricing in each period | Reduces operational and liquidity crunches, but says nothing directly about price risk |
| Concentration | Exposure to one counterparty, product or sector | Must allow for correlation, and may miss how correlations jump in stressed markets |
| Greek | Option sensitivities such as delta, gamma and vega | Carries model risk, and can be manipulated at desk level without independent controls |
| VaR | An aggregate statistical loss number | Model risk; easily misread by senior management; silent about how bad a stressed loss can be |
| Stress, sensitivity and scenario | Losses in plausible worst cases, in response to key variables, or in historical and hypothetical scenarios | Only as good as the firm’s knowledge of its exposures; never certain all bases are covered |
The weakness column is the reason firms use several limits together. A stop-loss limit catches losses already made, a notional or Greek limit stops a position growing too large, VaR gives one aggregate figure, and stress limits ask what happens when VaR’s normal-market assumption fails. Each covers a gap the others leave.
A desk’s notional limit is USD 100 million and its options book is at USD 60 million notional, comfortably inside the limit. Why might the risk manager still be worried, and which limits would address the concern?
Show answer
Notional amount can bear little relation to the economic risk of options. A USD 60 million book of short, near-the-money options can carry far more risk than its notional suggests, and that risk can jump as prices move. Greek limits on delta, gamma and vega would capture the sensitivity, and stress or scenario limits would show the loss in a sharp market move.
The Risk Transfer Toolbox
When a firm decides to transfer part of a financial risk to the markets, the instruments fall broadly into four families: forwards, futures, swaps and options. Each is a different tool with a different job, as Exhibit 3 shows.
| Instrument | Defining features |
|---|---|
| Forward | A tailored agreement to exchange an agreed quantity of an asset at a pre-agreed price on a future date, settled by delivery or in cash |
| Future | An exchange-listed forward with standardized terms, subject to daily margining |
| Swap | An OTC agreement to exchange the cash flows of two different positions until maturity, such as fixed against floating interest on a notional amount |
| Call option | The right, but not the obligation, to buy the underlying at the strike price, at maturity (European) or during a period (American) |
| Put option | The right, but not the obligation, to sell the underlying at the strike price, at maturity or during a period |
| Exotic option | Variations on standard options, such as average-price (Asian) options and basket options |
| Swaption | The right, but not the obligation, to enter a swap on pre-agreed terms at a future date |
The choice comes down to what the firm needs and what it will pay for. The central trade-off is between price certainty and flexibility. A forward fixes the price but obliges the firm to transact at that price and time, so it gives up any gain if the market moves the firm’s way. A call option sets a ceiling on the price while leaving the firm free to buy more cheaply if prices fall, but it costs an upfront premium.
Corvus Logistics will buy 2,000,000 gallons of diesel in three months. It can lock in a forward price of USD 3.00 per gallon, or buy call options with a strike of USD 3.00 for a premium of USD 0.12 per gallon. Find the total cost under each hedge if diesel ends at USD 3.50, and if it ends at USD 2.60.
Step 1. The forward fixes the cost whatever happens.
Step 2. With the call, if diesel ends at USD 3.50 the firm exercises and pays the strike plus the premium.
Step 3. With the call, if diesel ends at USD 2.60 the firm lets it expire and buys in the market.
Answer: the forward costs USD 6.0 million in both cases. The call costs USD 6.24 million if prices rise and USD 5.44 million if they fall. The USD 240,000 premium is what Corvus pays to keep the benefit of a price fall, and in the falling case that flexibility saves USD 560,000 compared with the forward. The forward suits a firm that values certainty above all; the option suits one that can afford the premium and fears being locked in at a high price while rivals buy cheaply.
Exchange-traded or over the counter?
The second key choice cuts across instrument types: is the contract traded on an exchange, or agreed privately over the counter (OTC)? Exchange-traded contracts are built to attract liquidity, so most can be traded easily and cheaply, and margining and netting through the exchange keep counterparty credit exposure low. The drawback is fit. Like a suit off the rack, a standard contract rarely matches the exposure exactly: it may reference a slightly different commodity, a different date or a different delivery location, and each mismatch creates basis risk. An OTC contract can be tailored to the exposure, but it carries counterparty credit risk, which tends to look small until a crisis makes banks and other counterparties suddenly look fragile. The growing use of central clearing in OTC markets has blurred this distinction.
A cocoa processor in Ghana hedges with exchange-traded cocoa futures that deliver in London. List two sources of basis risk and one advantage it gains over an OTC contract.
Show answer
Basis risk can come from location, because the futures price is set for delivery somewhere other than where the processor buys, and from timing, because contract expiry dates may not match its purchase dates; a difference in grade adds a third. In exchange for that imperfect fit, the futures contract offers liquidity, low trading costs and low counterparty credit risk through margining and the exchange’s netting.
Hedging Commodity Prices: Food, Drink and Fuel
Modern risk management arguably began with the agricultural futures listed on the Chicago Board of Trade in the 1860s. Farmers and food and drink producers still manage many commodity price risks this way, and large brewers are heavy users of derivatives across grains, sugar, energy and the aluminum in their cans. They typically use two different methods for two kinds of exposure.
For a widely traded grain such as wheat, a brewer can fix its purchase price with exchange-traded futures, hold them for some months, and then either take delivery or sell the contracts near expiry and use the proceeds to buy from its usual supplier. Either way, it has largely fixed the price for that period with a liquid, cheap contract. For aluminum, where the timing and local price of its needs matter more, the brewer is more likely to agree an OTC swap with a bank: it pays the bank a fixed price for a set quantity every few weeks, and the bank pays it the floating price its local suppliers charge. The tailored swap removes most of the basis risk a standard contract would leave. The bank, in turn, usually hedges its own side in the metals markets and earns a margin.
A brewer has agreed to pay a bank a fixed USD 2,400 per tonne on 500 tonnes a month, and to receive the floating market price. This month the market price is USD 2,700 per tonne. What does the swap pay, and what is the brewer’s net cost of aluminum?
Step 1. The swap settles the difference between floating and fixed.
Step 2. The brewer buys 500 tonnes from its supplier at the market price, then nets the swap receipt.
Answer: the bank pays the brewer USD 150,000, and the brewer’s net cost is USD 1.2 million, exactly 2,400 × 500. Had the price fallen to USD 2,200, the brewer would have paid the bank USD 100,000 and still ended at USD 1.2 million. The swap turns a volatile monthly cost into a fixed one, which is what the brewer is paying the bank for.
Airlines and the hedging dilemma
Fuel is one of an airline’s largest costs, as much as 15 to 20 percent of operating costs by GARP’s estimate, and airlines cannot simply raise fares when oil spikes, because fares follow passenger demand rather than costs. Since the mid-1980s, and especially after the 1990 to 1991 Gulf War sent energy prices sharply higher, the industry has hedged with swaps, call options, collars and futures. Few futures exist on jet fuel itself, so airlines often hedge with crude oil or heating oil contracts, which leaves them exposed to changes in the spread between those prices and jet fuel, as well as to timing and location basis. Many therefore use OTC contracts tailored to jet fuel and their delivery points.
There is still no industry agreement on whether airlines should hedge at all. Most hedge part of their fuel, some none. The case against is cost, and the danger of locking in a high price just before prices fall, which leaves the hedged airline looking far less profitable than unhedged rivals. The case for is that staying unhedged is also a bet. Southwest Airlines is widely reported to have saved more than USD 4 billion through fuel hedging between 1999 and 2008, a period of rising oil prices. Middle courses exist: hedging only part of the fuel bill, using options rather than forwards, or even buying a refinery, as one large US airline did in 2012, although owning a refinery brings its own exposure to crude prices and a business with its own cycles.
Managing Interest Rate and Currency Risk
Interest rate and currency risk are central for most large companies. A global restaurant group, for example, may borrow billions of dollars, mostly long term, in several currencies, and use swaps and foreign-currency debt to manage the interest cost and to hedge royalties and investments abroad, while buying supplies in local currencies wherever it can. Each of those choices is risk management, and many of them create natural hedges, such as matching foreign-currency debt against the foreign assets it finances. Whether to borrow in the same currency as an overseas operation is often the first decision, though in some markets it is not practical.
For interest rate risk, the basic task is to avoid taking on too much debt at high rates and to avoid too much exposure to floating rates. The balance is set by the board’s financial risk appetite, which may specify acceptable debt levels, and by the mix of fixed and floating debt, perhaps across several horizons. That appetite must be consistent with the firm’s target credit rating and with the covenants it has given its lenders. Even with a stable appetite, the environment keeps changing, for the reasons in Exhibit 4.
| Driver | Effect on the treasurer’s decisions |
|---|---|
| Firm risk appetite | Sets the key goals, such as debt levels and the fixed-floating mix |
| Market practicalities | It may be cheaper to borrow in one market and use derivatives to shift the currency or the fixed-floating profile |
| Changing business and financing needs | Deals mature and roll over, and the business grows |
| Cost center or profit center | Determines whether the treasurer may take a view on market direction |
| Regulation and tax | Changes in rules can change the best structure |
| Market direction and behavior | Rising rates, or a change in the shape of the yield curve, call for a response |
Rates also move with the wider economy and consumer demand, which can affect a firm’s ability to pay its debt. Floating-rate debt has one advantage here: when a slowdown brings rates down, the cost of servicing that debt falls just as the business weakens, a natural hedge. Treasurers manage the balance mainly with OTC interest rate swaps and currency swaps, returning repeatedly to the firm’s risk appetite and its usual directive, which is to create a more stable future around which the firm can plan.
Meridian Retail has USD 200 million of floating-rate debt paying the benchmark rate plus 1.5 percent. Its board wants interest costs fixed. Meridian enters a swap to pay a fixed 3.8 percent and receive the benchmark rate on USD 200 million. What is its all-in annual interest cost if the benchmark is 3.0 percent, and if it is 5.0 percent?
Step 1. Net the three flows: pay benchmark plus 1.5 percent on the debt, receive benchmark on the swap, pay 3.8 percent on the swap.
Step 2. Check the case where the benchmark is 3.0 percent.
Step 3. Check the case where the benchmark is 5.0 percent.
Answer: Meridian’s cost is fixed at 5.3 percent, USD 10.6 million a year, whatever the benchmark does. The benchmark it receives on the swap cancels the benchmark it pays on the debt, leaving the swap rate plus its own credit spread. Without the swap, a rise from 3.0 to 5.0 percent would have added USD 4 million a year to its interest bill.
What Can Go Wrong in Corporate Hedging
Almost everything can go wrong. A firm can misunderstand the type of risk it faces, map or measure it wrongly, miss a change in the structure of the market, or employ a rogue trader. Two failures stand out.
The first is a “risk management” program that is not really meant to manage risk. Using derivatives to lower the interest a firm pays sounds legitimate, but the price is often much more downside risk, or a structure that cuts payments now in exchange for ballooning payments later. Programs like this are often about flattering results to meet analyst forecasts, or hiding problems in the business. At worst they involve needlessly complex structures, leverage, or bets that sour after an event that looked unlikely but was entirely plausible, such as a sudden shift in rates or a jump in basis risk. That is a failure of corporate governance more than of risk management.
The second is poor communication about what a hedge will do. The classic case is MG Refining and Marketing (MGRM), the US subsidiary of the German group Metallgesellschaft. In the early 1990s it promised to supply customers with gasoline and heating oil at fixed prices for up to ten years, roughly 150 million barrels in total, and hedged that long-term commitment by rolling over large long positions in short-dated futures and swaps, which gain when oil rises and lose when it falls. In 1993 oil prices fell and the futures curve moved from backwardation into contango, so the hedges generated huge margin calls. The parent, alarmed by the cash drain, closed the hedges at a large loss, with losses commonly reported at between USD 1.3 billion and USD 1.5 billion. The market then moved the other way, against the now unhedged supply contracts. MGRM lost twice: first when it unwound the hedges, and then on the original contracts. The strategy might well have worked if it had been carried through. No rogue trader was involved; the failure was not anticipating the liquidity the hedge would need, and not explaining it to the people who could pull the plug.
Anvil Fuels has agreed to buy 1,000,000 barrels of crude from a producer in one year at a fixed USD 70, and has sold futures on 1,000,000 barrels at USD 70 to hedge the value of that commitment. Over the next month the oil price rises to USD 82. What cash does the hedge consume, and what has happened to the value of the position overall?
Step 1. Futures are marked to market daily, so a short position pays variation margin as the price rises.
Step 2. The fixed-price purchase contract has gained the same amount in value, but that gain arrives only when the oil is delivered in a year.
Answer: the position as a whole is still hedged, with a USD 12 million futures loss offset by a USD 12 million gain on the contract, but Anvil must find USD 12 million of cash now and wait a year for the offsetting gain. A firm that has not planned for this funding need may be forced to close the hedge at the worst moment, which is the trap MGRM fell into. A hedge has to be judged on its cash flows as well as its value.
Most of these disasters could have been avoided with a few habits for conservative users of derivatives:
- Set clear goals, and keep instruments and strategies simple.
- Disclose the strategy and explain what it could do in different markets.
- Give the program resources and limits that suit the strategy.
- Stress test, and set up early warning indicators.
- Watch for counterparty risk and break clauses.
- Think through many market scenarios, including the cash needed for margin calls.
The world rarely hears about hedges that work, or about the firms that would have failed without a well-run, well-explained program, and most professionals expect corporate use of derivatives to keep growing. What separates the successes from the failures is less the instrument than the culture around it. A firm can test that culture: does it regularly talk about risk and respond to warning signs and near misses, has it checked that key staff share an understanding of its risk appetite, and can its board name the firm’s top ten risks? A risk manager who stabilizes a volatile exposure over three years has done a difficult job, and that success should be part of a plan the whole firm and its stakeholders already understand.
A firm has a perfectly offsetting hedge: a USD 30 million loss on its futures is matched by a USD 30 million gain on its fixed-price supply contract. Why might this still be a problem?
Show answer
The futures loss is paid in cash now through margin calls, while the gain on the supply contract arrives only when it is delivered, perhaps years later. If the firm cannot fund USD 30 million of margin, it may be forced to close the hedge at the worst moment and end up unhedged, which is how MGRM lost twice in 1993. A hedge must be judged on its cash flows and funding needs, not only on its value.
Chapter Summary
- Firms have managed financial risk more intensively since the 1970s because volatility rose and new instruments made hedging possible, but the same instruments can quietly turn a hedge into a bet.
- The road map runs from risk appetite, through mapping and choosing strategies, to putting the appetite into operation, implementing and re-evaluating.
- Theory says diversified shareholders gain little from firm-level hedging; real-world frictions such as distress costs, creditor concerns and the need to plan make hedging valuable.
- Risk appetite sits below risk capacity and above the current risk profile, and it is made operational through policies, limits and several risk measures.
- Risk mapping measures exposures at the cash flow level and reveals natural hedges, so only the net exposure needs a derivative.
- The four strategies are retain, avoid, mitigate and transfer, chosen on cost, benefit and fit with the appetite, with costs that are rarely fully visible.
- The risk function must be rightsized to the strategy, with independence, clear accounting treatment and enough expertise to avoid depending on dealers.
- Every limit type has a weakness, so limits are layered.
- Forwards give certainty without flexibility, options give flexibility for a premium, swaps fix costs over time, and exchange contracts trade fit for liquidity and low credit risk.
- Commodity, interest rate and currency hedges follow the same logic, from futures and swaps for a brewer to swaps that fix a borrower’s interest cost.
- Hedging fails through programs that are not really risk management and through poor communication of a hedge’s cash needs, as MGRM showed in 1993.
Frequently Asked Questions
How do firms manage financial risk?
Firms map their exposures to prices, rates and currencies, net out natural hedges, and then decide for each remaining risk whether to retain, avoid, mitigate or transfer it, within a board-approved risk appetite. Risks they transfer are usually hedged with forwards, futures, swaps or options, and the whole program is controlled with risk limits and reviewed regularly.
What is the difference between risk appetite and risk capacity?
Risk appetite is the amount and type of risk a firm is willing to accept in pursuit of its goals. Risk capacity is the maximum risk it can absorb before it becomes insolvent or breaches a binding constraint. Appetite is set deliberately below capacity, and the firm’s current risk profile should sit below its appetite.
Why would a firm choose not to hedge?
Hedging has transparent costs such as option premiums and hidden costs such as errors and rogue trading, and it can stabilize results only over a few years. Shareholders with diversified portfolios have already diversified away firm-specific risk, and some buy a stock precisely for its exposure to a commodity. A firm may also prefer to keep a risk that is natural to its business.
What are the main hedging strategies and instruments?
The main instruments are forwards, futures, swaps and options, with exotic options and swaptions for special needs. A forward or swap fixes a price or rate, an option caps it while keeping the benefit of a favorable move for a premium, and futures do the job of a forward on an exchange with daily margining and less counterparty risk.
What is a natural hedge?
A natural hedge is an offset that arises from the business itself, such as foreign currency receipts matched by payments in the same currency, or foreign-currency debt matched against the foreign assets it finances. Natural hedges cost nothing, so firms identify them through risk mapping and hedge only the net exposure that remains.
Why do firms use several types of risk limit?
Each limit captures one aspect of risk and misses others. A stop-loss limit acts only after losses occur, notional limits ignore the true risk of options, VaR says nothing about stressed losses, and concentration limits may miss how correlations jump in a crisis. Layering limits lets each one cover the gaps left by the others.
What went wrong with the MGRM hedging program?
MGRM sold oil products at fixed prices for up to ten years and hedged with short-dated futures and swaps. When oil prices fell in 1993 and the futures curve moved into contango, the hedges produced huge margin calls. The parent company closed the hedges at a loss, and the market then turned against the unhedged supply contracts, so MGRM lost twice. The lesson is to plan for a hedge’s cash needs and communicate them.
