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You are the Chief Risk Officer (CRO) at a non-financial company and the board of directors has asked you to make a recommendation with respect to hedging one of the firm’s key exposures. The board wants you to make a recommendation of either “in favor” or “against” the implementation of a hedge against the exposure. Your staff prepared the following arguments, three in favor and three against: Three Arguments AGAINST hedging an exposure at a non-financial firm
1) Our investors own diversified portfolios such that in theory our firm’s specific risks are effectively costless to them.
2) If markets are perfect, hedging is a theoretically a zero-sum game
3) Practical (non-theoretical) objections include that risk management requires specialized skills; and can incur high compliance costs Arguments IN FAVOR of hedging an exposure at a non-financial firm
1) Financial distress incurs a high fixed costs, which is a salient market imperfection
2) Risk management gives management better economic control over the firm’s natural economic performance
3) Hedging has the potential to reduce the firm’s cost of capital, reduce its cash flow volatility, and enhance its ability to grow Which of these arguments is valid, or at least plausible?
A. None of the arguments are valid
B. Each set of arguments contains one mistake (or fallacy) and two valid arguments
C. Each set of arguments contains two mistakes (or fallacies) and one valid argument
D. All of the arguments are valid in both sets
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