Nearly all corporate CFOs realize that risk management can be an important financial tool. But too few understand how to design appropriate risk management strategies for their firms or appreciate how much value such strategies can create. In a world in which emerging markets play an ever greater role, the importance of a carefully constructed risk management strategy has never been as pressing.
A new report from Citigroup, entitled Creating value by hedging risk in the emerging markets, reveals that a 10% reduction in earnings volatility is associated with a 2.9% increase in market-to-book valuation premium among emerging market firms. Put simply, companies based in the emerging markets, or based elsewhere but with exposure to the emerging markets, can create millions of dollars of additional value just by managing their FX, interest rate and commodity risks better.
The benefits of employing sound hedging programmes don’t stop just there. When a company has a more stable and predictable cashflow it is better able to plan its funding requirements and service its debt more efficiently. This, in turn, could lead to a boost in its credit ratings. In addition, hedging enables companies to manage rising costs without significantly affecting margins. Airlines, for example, are able to remain competitive despite rising fuel costs through the use of derivatives.
So, with all these obvious advantages, why don’t more companies employ better strategies?
A big reason is that some CFOs don’t know how to incorporate their risk management within the overall corporate strategy. They might understand the technical aspects of risk management but not the strategic rationale. What’s important is to tailor the hedging policy so it makes most sense for that particular firm. That means adopting a risk management strategy that is flexible, long-term in its approach but aware of the short-term price considerations of different hedging products, takes into account the hedging strategy of competitors, understands what exposures need to be hedged, and, in certain circumstances, what exposures don’t.
For direct commodity players, such as oil majors, which have cash-heavy balance sheets and little or no debt, hedging doesn’t make much sense right now as their investors want exposure to the underlying risks. But these types of companies are few and far between.
One positive is the rapid development of local capital markets. They are helping in two ways. The first is in the growth of local long-term derivatives products. In India, for example, the tenor on cross-currency swaps goes out to 10 years; in South Africa it’s 30 years, according to Citigroup. In South Korea’s FX forward market, the longest tenor is five years, while the options market goes out to 10 years.
Another advantage of deepening local-currency bond markets is that they provide a natural hedge. Companies can now borrow long-term, liquid instruments close to home.
Constraints still exist and the derivatives markets in the developed world have more products with greater sophistication than those in emerging markets. Too many companies, such as airline Gol in Brazil, are still forced to look to the US markets to find the appropriate products and pricing. Still, these will develop over time.
What matters more is that emerging markets are becoming more central to corporate executives. The rewards are potentially great, as long as the risks are understood.
