Financial Management

Why does hedging reduce risk?

Hedging is the balancing of a risky position with an equal and opposite risky position. Effectively, hedging creates a portfolio of risky positions in which the elements of the portfolio are negatively correlated. Although each component remains risky, the portfolio has far less¾and possibly no¾risk. Losses in value from one element of the portfolio are matched by increases in value from other elements.

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What is the difference between hedging across the balance sheet and hedging individual cash flows?

The difference is in which risky positions are balanced out. Hedging across the balance sheet matches assets and liabilities by their maturities to ensure that assets will become liquid as needed to pay the company’s liabilities. Hedging individual cash flows ensures that receipts can be used efficiently and each obligation has a known cost.

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What are the four steps in putting working capital on the balance sheet?

he four steps represent a logical way to think about filling out the balance sheet in order to (1) only accept investments with positive NPV, (2) maintain the appropriate debt-equity mix, and (3) hedge across the balance sheet. The four steps are generally done in sequence, but are repeated many times as conditions and opportunities change. The sequence is:

(1) Establish balances for each permanent current asset using the incremental techniques

(2) Establish balances for each permanent current liability by locating all low-cost or free short-term financing opportunities using the effective interest rate analysis

(3) Add additional permanent debt, both short-term and long-term to hedge the maturities of the assets on the balance sheet.

(4) Respond to temporary current asset buildups and take advantage of any opportunities arising from temporary working capital.

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Attractive short-term financing opportunities

Why are the “attractive short-term financing opportunities,” described in the second step of the four-step process, considered before other debt financing?

These opportunities are considered first simply because they are less costly. They include such financing sources as wages payable, taxes payable, and free trade credit. It is always wise for financial managers to raise financing at the lowest possible cost.

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How is the current ratio used in setting the debt maturity mix?

How is the current ratio used in setting the debt maturity mix? Can you think of any other financial measures that could also be used in this analysis?

The current ratio is often used as a measure of how to split the amount of debt taken in the third-step of the four-step process between current and long-term to hedge balance sheet maturities. Short-term debt is added to the firm’s liabilities until the current ratio reaches a target value; additional debt financing is long-term. Other measures that could be used are working capital (current assets minus current liabilities) and the quick ratio.

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Debt maturity mix

What role does the debt maturity mix play in the firm’s overall risk-return posture?

The debt maturity mix is an important input to a company’s levels of risk and return. In general, short-term liabilities are less costly than long-term debt, since the yield curve is normally upward sloping. However, a firm with a high level of short-term liabilities has less liquidity than one whose debt is of longer maturities. In summary, a company which weights its debt financing toward the short-term increases both its return and risk, while a company which weights its debt financing toward the long-term decreases both its return and risk. By establishing its debt maturity mix, a company can add or subtract both risk and return to its risk-return position.

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Why is the debt maturity mix normally simplified to short- vs. long-term debt?

Why is the debt maturity mix normally simplified to short- vs. long-term debt? What, if anything, is lost in making this simplification?

This simplification is normally made to be consistent with the way assets and liabilities are categorized on the balance sheet. However, simplifying in this way hides the opportunity, and need, to consider a much finer hedging of assets and liabilities. For example, an asset that will turn to cash in one month is generally not a good hedge for ten-month debt, yet both would appear on the balance sheet as current items. An asset with a 30-year life is generally not a good hedge for thirteen-month debt, yet both would appear on the balance sheet as long-term. It is important to look beyond the simplicity of the balance sheet classification and examine the maturities of assets and liabilities in more detail.

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What role do permanent current assets play in maturity-range hedging?

Even though individual current assets turn over within the annual accounting period, the balance of permanent current assets has a long-term maturity since it will be on the books for many years. Recognizing this, we include permanent current assets with noncurrent assets when grouping assets by maturity for maturity-range hedging.

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Distinguish between individual asset/liability hedging and maturity-range hedging?

Distinguish between individual asset/liability hedging and maturity-range hedging? What type of company can do each?

Individual asset/liability hedging, involves matching the maturities of specific assets with specific liabilities. Each liability is offset with an asset of equal amount and maturity. While this strategy achieves the maximum risk reduction from hedging, it is costly, difficult, and time-consuming to do. With maturity-range hedging, assets and liabilities are grouped by maturity and the groups are kept roughly equal in size. This policy is far less costly and more doable than attempting to match every asset and liability. Effectively, maturity-range hedging is an attempt to back off from individual asset/liability hedging to find a practical balance sheet hedging policy.

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Why do companies deviate from maturity-range hedging?

Companies deviate from maturity-range hedging for three primary reasons:

(1) Inability to obtain the desired financing – Small businesses often cannot obtain funds in the maturities needed for hedging purposes. They have difficulty raising long-term capital and tend to weight their financing toward the available shorter-term trade credit and bank financing.

(2) Cost reduction (higher returns) – Some companies elect to use more short-term financing than required for hedging since it is lest costly when yield curves are normal. Other companies elect to use more long-term debt to avoid the costs of repeatedly renewing and renegotiating their financing.

(3) Risk reduction – Some companies elect to use more short-term financing than required for hedging since it gives them a high degree of flexibility in adding and subtracting debt from the balance sheet should their needs change. Other companies elect to use more long-term debt to lock in interest rates, improve their credit ratings, and avoid the danger of bankruptcy from having to repay debt on an ongoing basis.

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