Cash Flow Hedging A Cautionary Note

One thing to notice is that, in our discussion thus far, we have talked conceptually about hedging the value of the firm. In our example concerning wheat prices, however, what

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

23. Risk Management: An Introduction to Financial Engineering

© The McGraw-Hill Companies, 2002

PART EIGHT Topics in Corporate Finance is really hedged is the firm's near-term cash flow. In fact, at the risk of ignoring some subtleties, we will say that hedging short-term financial exposure, hedging transactions exposure, and hedging near-term cash flows amount to much the same thing.

It will usually be the case that directly hedging the value of the firm is not really feasible, and, instead, the firm will try to reduce the uncertainty of its near-term cash flows. If the firm is thereby able to avoid expensive disruptions, then cash flow hedging will act to hedge the value of the firm, but the linkage is indirect. In such cases, care must be taken to ensure that the cash flow hedging does have the desired effect.

For example, imagine a vertically integrated firm with an oil-producing division and a gasoline-retailing division. Both divisions are affected by fluctuations in oil prices. However, it may well be that the firm as a whole has very little transactions exposure because any transitory shifts in oil prices simply benefit one division and cost the other. The overall firm's risk profile with regard to oil prices is essentially flat. Put another way, the firm's net exposure is small. If one division, acting on its own, were to begin hedging its cash flows, then the firm as a whole would suddenly be exposed to financial risk. The point is that cash flow hedging should not be done in isolation. Instead, a firm needs to worry about its net exposure. As a result, any hedging activities should probably be done on a centralized, or at least cooperative, basis.

economic exposure

Long-term financial risk arising from permanent changes in prices or other economic fundamentals.

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