1-13FRM（Financial Risk Manager）金融风险管理师

Corporate Risk Management: A Primer

公司风险管理：入门知识

2-13FRM（Financial Risk Manager）金融风险管理师

Hedging Risk Exposures

Evaluate some advantages and disadvantages of hedging risk exposures

Disadvantages

There are some theoretical reasons for a firm not to hedge risk exposures but most of

those reasons make the unrealistic assumption of perfect capital markets, which is not

realistic. Also, they ignore the existence of the significant costs of financial distress

and bankruptcy. However, in practice, there are some valid reasons not to hedge,

including the distraction from focusing on the core business, lack of skills and

knowledge, and transaction and compliance costs.

Advantages

Many reasons exist for a firm to hedge its risk exposures. Key reasons include

lowering the cost of capital, reducing volatility of reported earnings, operational

improvements, and potential cost savings over traditional insurance products.

3-13FRM（Financial Risk Manager）金融风险管理师

Hedging Decisions

In hedging specific risk factors, it is necessary to consider the role of the board of

directors as well as the process of mapping risks. The board, together with

management, should set the firm’s risk appetite using one or more of the following

tools: qualitative statements of risk tolerance, value at risk, and stress testing. Risk

management goals must be clear and actionable and there should be clarification

whether accounting or economic profits are to be hedged. Likewise, there should be

clarification whether short-term or long-term accounting profits are to be hedged.

Other points the board should consider include the time horizon and the possibility of

implementing definitive and quantitative risk limits.

Mapping risks requires clarification as to which risks are insurable, hedgeable,

noninsurable, or nonhedgeable. Mapping risks could be performed for various risks

such as market, credit, business, and operational. Essentially, it involves a detailed

analysis of the impacts of such risks on the firm’s financial position (balance sheet)

and financial performance (income statement).

4-13FRM（Financial Risk Manager）金融风险管理师

Hedging Operational and Financial Risks

Hedging operational risks covers a firm’s activities in production (costs) and

sales (revenue), which is essentially the income statement. Financial position risk

pertains to a firm’s balance sheet. Making the realistic assumption that there are

some imperfections in the financial markets, a firm could benefit from hedging

financial position risk. Hedging activities should cover both the firm’s assets and

liabilities in order to fully account for the risks.

① Pricing Risk

With production, the cost of inputs may have a significant impact on the firm’s ability

to conduct its business in a competitive manner. Therefore, it makes sense to hedge

such pricing risk by purchasing a forward or futures contract to buy a specific quantity

of that input at a fixed cost determined in advance. The same could be done with a

firm’s domestic or foreign sales, as will be discussed next.

5-13FRM（Financial Risk Manager）金融风险管理师

Hedging Operational and Financial Risks

② Foreign Currency Risk

The goal of hedging foreign currency risk is to control exposure to exchange rate

fluctuations that impact future cash flows and the fair value of assets and liabilities.

Revenue hedging can be used when a firm has sales to customers in foreign countries

(with payment in the foreign currency). There is the risk of the devaluation of the

foreign currency in the future, resulting in losses to the firm when the funds are

ultimately converted back to the domestic currency.

③ Interest Rate Risk

The goal of hedging interest rate risk is to control the firm’s net exposure (asset or

liability) to unfavorable interest rate fluctuations.

6-13FRM（Financial Risk Manager）金融风险管理师

Static vs. Dynamic Hedging Strategies

A static hedging strategy is a simple process in which the risky investment

position is initially determined and an appropriate hedging vehicle is used to

match that position as close as possible and for as long as required.

In contrast, a dynamic hedging strategy is a more complex process that

recognizes that the attributes of the underlying risky position may change with

time. Assuming it is desired to maintain the initial risky position, there will be

additional transaction costs required to do so. Significantly more time and

monitoring efforts are required with a dynamic hedging strategy.

7-13FRM（Financial Risk Manager）金融风险管理师

Risk Management Instruments

Once the risks are mapped, management and the board need to determine which

instruments to use to manage the risks. The relevant instruments can be classified

as exchange traded or over the counter (OTC).

Exchange-traded instruments are generally quite standardized and liquid.

OTC instruments are more customized to the firm’s needs and therefore less

liquid. An element of credit risk is also introduced with OTC instruments.

8-13FRM（Financial Risk Manager）金融风险管理师

Example

1. Melody Li is a junior risk analyst who has recently prepared a report on the

advantages and disadvantages of hedging risk exposures. An excerpt from her

report contains four statements. Which of Li’s statements is correct?

A. Purchasing an insurance policy is an example of hedging.

B. In practice, hedging with derivatives is not likely to be a zero-sum game.

C. The existence of significant costs of financial distress and bankruptcy is

considered within the assumption of perfect capital markets.

D. Hedging with derivatives is advantageous in the sense that there is often the

ability to avoid numerous disclosure requirements compared with other

financial instruments.

9-13FRM（Financial Risk Manager）金融风险管理师

Example

1. Answer:

10-13FRM（Financial Risk Manager）金融风险管理师

Example

2. The involvement of the board of directors is important within the context of a firm’s

decision to hedge specific risk factors. Which of the following statements regarding

the setting of risk appetite is correct?

I. Risk appetite may be conveyed strictly in a qualitative manner.

II. Debtholders and shareholders are both likely to desire minimizing the firm’s

risk appetite.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

11-13FRM（Financial Risk Manager）金融风险管理师

Example

3. Lear, Inc., is a U.S. wine producer that purchases a significant amount of cork (

软木塞) for its wine bottles from Asia. It also sells much of its wine to customers

throughout North America. Based on these two broad transactions, which of the

following risks does Lear, Inc., most likely face?

A. Financial position risk and operational risk.

B. Operational risk and pricing risk.

C. Pricing risk only.

D. Financial position risk, operational risk, and pricing risk.

12-13FRM（Financial Risk Manager）金融风险管理师

Example

4. Which of the following statements regarding exchange-traded and over-the-

counter (OTC) financial instruments is correct?

A. There is greater liquidity with exchange-traded financial instruments.

B. There is greater customization with exchange-traded financial instruments.

C. There is greater price transparency with OTC financial instruments.

D. There is credit risk by either of the counterparties inherent in exchange-

traded instruments.

13-13FRM（Financial Risk Manager）金融风险管理师

结 束

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