Free Custom «Financial Benefits of Hedging» Essay Paper

Introduction

In the financial sector financial hedging refers to the act of implementing market positioning strategies in offshore or other less riskier markets with an aim of avoiding or minimizing the effect of exposing the market deliverables to an impending financial risk. This is usually resulting from the sudden progressive and unforeseen effects of price fluctuations in the common traditional markets. Hedge funds are primarily targeted at reducing the effect of volatility resulting from occurring market risks with an aim of conserving capital needs while ensuring positive market returns irrespective of the change in market conditionality (Gilbert and Paulina, 2008).

Critical Organizations Associated with Hedging

There are various critical organizational settings which are involved in the hedge funds phenomenon and some of them come from agricultural sectors, real estate sectors, airlines industry, financial stock markets, and insurance industries among other small and medium critical financial investment portfolios. In recent times, there has been observed positive growth in the hedge fund industry leading to an improved growth of net asset flows in terms of the concurrent estimates in the financial sector (Gilbert and Paulina, 2008).

 

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Analysis Where Data is Available

In scenarios where data is available it would be important to perform critical analysis on the organization’s financial statements using financial ratios. Here the main aim is to perform a critical evaluation of the existing financial securities through appraisal of management and subsequent financial performance. In this manner, a competent financial analyst will first establish a well laid out plan for performing an extensive financial modeling exercise judging on the industrial components of the industry in focus at that specific time.

The aim of financial modeling is to carry out financial ratio calculations based on the provided parameters. Consider the following scenario of a company named Cristen Shoes Industries exporting shoes to an offshore market, for instance, the United Kingdom. Suppose the currency value projection of the British Sterling pound for next year is at US$ 1.40, US$ 1.50, and US$ 1.60 respectively (Grinblatt & Titman, 2002). The company would then have varying values for its assets and concurrent sales. For instance, the values under the three projections could be US$ 105 million, US$ 140 million, and US$ 160 million respectively (Grinblatt & Titman, 2002). The company can decide to purchase British pounds based on the forward market projected value at a value which falls between the projected values.

This could be sufficiently implemented by entering a forward contract for Cristen Shoes Industry at a value at which the risk for investment will be significantly neutralized. For instance, by purchasing a forward contract at US$ 1.52 the company stands to realize a forward value of US$ 138 million for the following year (Grinblatt & Titman, 2002).  The firm therefore benefits by hedging as its value exceeds the real value at which the company’s value would stand. By taking the decision to buy the forward contract at US$ 1.52 the company successful works against negative incident that would result from the impending uncertainty due to fluctuations resulting in the varying currency values, which has a negative impact in terms of the exchange rates.

Another scenario could arise in the wake of tax provisions required by state regulations for all individuals, companies and franchise arrangements. “Tax gains accrue from hedging because of an asymmetry between the tax treatment of gains and losses. A U.S corporation that has earned $100 million will pay about $35 million in federal income taxes” (Grinblatt & Titman, 2002).  If the company undergoes a loss of $100 million the IRS stands to rebate the company’s share of losses only up to the previous two years, therefore, the company stands to lose more value accruing from a $100 million gained after pretax (Grinblatt & Titman, 2002).

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A firm in this kind of a situation can successfully, through hedging its financial risks in order to work against the effect arising from uncertainties arising from this market. Cogen Pharmaceuticals is a company specialized in selling arthritis drugs for arthritis patients. Majority of its payments are generally received in terms of the standard European currency, the euro. The fact that the company has most of its costs dominated by U.S dollars hence it stands to be exposed to an impending currency risk (Grinblatt & Titman, 2002). The fact that tax the fluctuation in currencies presents the only source of financial risk in its performance, its hedging and non-hedged projections would be present in this manner:

Pretax Income for Two Equally Likely Scenarios

(Grinblatt & Titman, 2002)

In this scenario, the company may make loses it chose not to hedge especially when there is profits deduction on both profits and losses accrued by the company. Taking the assumption that there is a tax of 40% being applied to all instances of losses and profits the data would be as follows

After Tax Income for Two Equally likely Scenarios

(Grinblatt & Titman, 2002)

The firm stands a good chance of regaining from its projected profits and losses to the asymmetric treatment being given to both scenarios, therefore, the firm can significantly reduce their projected tax liabilities by performing a hedging operation (Grinblatt & Titman, 2002). Even in the event a geometric mean was to be performed in the same data then there is a high possibility that reduction in risk would be highly significant. “The reduction in risk also shows up in the geometric mean return. The geometric mean return is the way portfolio management is most often judged and it is of special interest since a reduction in risk by international diversification will result in an increased geometric mean return, even if the arithmetic mean is unaffected” (Ghosh & Ortiz, 1997). Here hedging has been used to avoid an impending financial distress for the corporation, which normally leads to a significant drop in the performance of the company.

Analysis Where Data is Unavailable

Various types could be performed where data is unavailable then carrying out a futuristic assessment of the industry and market variables would come necessary in order to avoid a predictive fall out in terms of business strategies implementation, for instance, in the event the firm in consideration has a significant number of players in the same industry. In this case, it would be important to extract standard information from financial statements which running across multiple years in order to give way to a figurative performance based on a timing element, for instance, two running data (Gilbert and Paulina, 2008). This would enable the financial analyst to project the market variables based on that particular period of financial year.

The fact that we are taking into consideration a financial comparison of a company which has several players in its industry, a critical analysis of the standardized information of the different companies’ financial statement would be necessary (Gilbert and Paulina, 2008). Focus would be on the different size elements in order to curve out a specific market niche to which the company in question belongs. This would essentially result in a discreet comparison of different company sizes going by the resulting financial model.

Alternatively, one would pursue establishing key measurement criteria of matching the different relationships of the resultant costs and benefits. The analytical perspective pursued would entail carrying a comparison over a specific period of time across the different firms using the financial model proposed. Ordinarily the data needed would entail industry performance data, capital requirements data, liquidity data, and solvency data (Gilbert and Paulina, 2008). This would critically be analyzed using key performance ratios, solvency ratios focusing on the long term achievements and effect, starting and working capital ratios, and resultant liquidity ratios. Performing an analysis and critique based on all these variables, the firm will be in a position to establish its operational performance, business stock movement, and resulting risk factors to which the business is sufficiently exposed. For instance, focusing on the liquidity ratios analysis one would consider various elements, which could include liabilities in the form of taxes (Gilbert and Paulina, 2008). Alternatively, focusing on the long term solvency ratios elements in consideration would include a critical assessment of the company assets variables, equity variables, and interest levels payable on the total profits accrued by the firm.

Approach Most Appropriate At this Time.

The period starting from 2007 to present has been featured with instances of financial crisis resulting from a liquidity problem experienced in the United States’ banking sector (Gilbert and Paulina, 2008). This has led to the subsequent falling of huge multinational corporations and critical financial institutions in the economic arena. This led to a huge bailout program being launched by the majority of national governments coupled with various financial stimulation packages as witnessed in the United States. The impact of the risks in the financial markets is still evident in the present 2010 to 2011 economic scenario due to the instability levels of most leading currencies (Gilbert and Paulina, 2008).

The best hedging strategy to use in the current economic situation is the emerging market strategy. This essentially involves the pursuance of an investment criterion targeting equities and emerging debts in markets which portray high levels of inflation and volatility (Gilbert and Paulina, 2008). A more feasible approach of using emerging markets is through the subsequent investment in the securities of companies of sovereign debt companies locate in the some of the emerging economies where the effect of the economy crisis is presenting an advantage to the firms found therein. “Emerging markets include countries in Latin America, Eastern Europe, the former Soviet Union, Africa and parts of Asia” (Eichengreen, Mathieson, Chadha, & International Monetary Fund, 1998). Considering the fact that the most affected countries by the financial crisis were the major superpowers, multinationals located in the United States, and European would by securities in these emerging markets in order to avoid an impending financial distress. Moreover, emerging markets could pursue global funds with an aim of shifting the weighting found in these regions going by the market conditions and managerial perspectives (Eichengreen, Mathieson, Chadha, & International Monetary Fund, 1998).

Focusing on the emerging markets, equity hedges could be successfully established with short sales of stock and presented index options (Eichengreen, Mathieson, Chadha, & International Monetary Fund, 1998). This would substantially hedge against other economic risks resulting from the interaction among constantly fluctuating market factors. However, there are companies which prefer maintaining a small portion of their assets existing in the hedge structure, which are ordinarily employed through significant leverage (Eichengreen, Mathieson, Chadha, & International Monetary Fund, 1998).

Evolving Issues with regard to Hedge Funds

There are various evolving issues associated with the practice of hedging especially in view of the current and previous financial crisis situations. There is a constantly growing speculation over the role played by hedge funds in the impending financial crises. “The criticism has mainly been that a highly leveraged hedge fund or group of hedge funds could have a strong impact on prices on the financial markets by launching speculative attacks on certain companies, sectors and currencies” (Stromqvist, 2009). This effect has an overarching effect especially in certain offshore companies when pursuing the emerging market strategy of hedging. In addition to this, hedge funds are speculated to result in a conspicuous herd behavior among investors (Stromqvist, 2009). Naturally investors would tend to flock to places where the attribution risk factors are much less than other localities. Moreover, hedge funds have also led to the manipulation of asset prices which has consequently contributed to the developing trends in the financial markets (Stromqvist, 2009).

Recommendations

This would entail setting up limits for firms entering into the hedging approach to discourage its abuse. In as much as the main aim of business approaches is to leverage risk components found in the financial markets, more care needs to be practiced towards hedging to avoid exploitation of accompanying market variables. However, a more feasible approach would entail the institution of certain standards to which firms interested in pursuing hedge funds first carry out a thorough evaluation of their financial statements using standard ratios (Gilbert and Paulina, 2008).