Abstract
The aim of this term paper is to supply an analysis on the rationales for corporations to apply hedging and hedge accounting. In order to do so, P. M. DeMarzo and D. Duffie’s paper “Corporate Incentives for Hedging and Hedge Accounting” published 1995 will be reviewed and analysed.
This term paper will start with a short review of the literature on corporate risk management and hedging policies and then move on to a description of the model developed by DeMarzo and Duffie and its rationale. Then, their findings and propositions will be presented followed by the conclusion.
Literature Review
“Corporate Incentives for Hedging and Hedge accounting” by P. M. DeMarzo and D. Duffie is a paper published 1995 in The Review of
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In 2008, Muller and Verschoor, published a study on 471 non-financial European firrms from the UK, Netherlands, Germany and Belgium. In this study they aim to investigate the informational effect of disclosing derivative positions. It is an interesting matter since European firms did not disclose any of this information until 1990. The study focuses on the usage of foreign exchange derivatives while also investigating the condition in which a firm decides to employ these instruments and to which extent. Even though they have found evidence of the firms using derivatives, their study presented weak results in terms of informative effect of derivative position disclosure.
Model
DeMarzo and Duffie build a model in their paper in order to illustrate the relationship between investors, accounting information and managers’ incentive. It involves other factors such as the choice between accounting and economic risk hedging, derivative position disclosure, firm reputation and volatility of managers’ future wages. To illustrate their interaction consider the following graph:
Description of the Model
DeMarzo and Duffie’s model builds upon the one from Holmstrom and Ricart i Costa (1986). The time frame is two periods. Total profits without hedging after period 1 is denoted as X+ θɛ, where X=a+e+m is a profit component dependent on project quality e and manager’s capability a as well as
According to these it can be concluded that GM Corporation’s risk management policy is based on a mostly passive hedging strategy. In general, passive hedging is used by highly risk-averse companies that
American Barrick is the largest gold producer in North America. The implementation of the gold-hedging program differentiated the firm from other major gold rivals and improved its reserve and financial strength. In 1995, American Barrick ’s latest gold find necessitated the company to determine a new hedge strategy for its gold production.
Mr. Lee and the other executives expect to generate a higher profit from hedging since they have majority of their personal wealth invested into the firm. The focus of any hedging program should always be to minimize the firm’s risk of loss, but that does not mean the they will
Based on the 1988 Supreme Court case of Corn Product Refining Co. v. Commissioner (350 U.S. 46; 76 S.Ct. 20; 100 L.Ed. 29), hedging transactions were determined to be used to support business practices of certain commodities. Such hedging transactions are normal for businesses engaged in commodity sales such as coal or corn to protect against market
The 1990s and the early 2000s was a time that the world witness an explosion of fraud in the corporate world. Corporate fraud like Enron, HealthSouth, Waste Management, WorldCom, Lehman Brothers, etc. was so disturbing that lawmakers felt the need for a law to help curb down these frauds. Lawmakers came out with Sarbanes Oxley named after Senator Paul Sarbanes and Rep. Michael G. Oxley, the co-sponsors of the act. The purpose of this essay is to discuss some of the tax advantages and disadvantages of Sarbanes-Oxley and to explore whether the advantages outweigh the disadvantages for small businesses as well as the tax benefits for those businesses.
The current 50% hedging policy executed at the fund level has served well for OTPP for the past ten years, contributing to the fund’s positive returns. The FX Hedge Program not only has minimized the downside risk, but has also limited the upside potential. If OTPP decided not to implement a hedging program in 1996, they would have lost about $983 million CAD over the ten year period (1995-2005) which is valued at 2% of the portfolio. With the hedging program, OTPP was able to reduce the overall loss to about $469 million CAD, but also limited the gain from the depreciation of the pound.(Exhibit 1) Hedging is an excellent short-term risk minimizing strategy for long term investors, sustaining a continual payout of pensions during volatile times in OTPP’s invested currency markets. Currently, approximately 21% of OTPP’s net assets are exposed to foreign currency risk. Consequently, it is essential that OTPP maintain a risk management program of hedging, as slight currency fluctuations can significantly affect the value of the fund. Similarly to continual renewal of swaps, hedging can be a very expensive risk management strategy.
This case explores the operating exposure of Jaguar PLC in 1984, just as the government is about to relinquish control and take the company public via an IPO. The primary concern of the CFO is that Jaguar sells over 50% of its cars in the US, while its production costs and factories are U.K.-based. This currency mismatch creates operating exposure for the firm that needs to be hedged.
This case explores the operating exposure of Jaguar PLC in 1984, just as the government is about to relinquish control and take the company public via an IPO. The primary concern of the CFO is that Jaguar sells over 50% of its cars in the US, while its production costs and factories are U.K.-based. This currency mismatch creates operating exposure for the firm that needs to be hedged.
In order to reduce risk, the company is using two hedging derivatives: forward contracts and put options to sell dollars. The aim of the paper is to determine an appropriate hedging policy which answers two main questions: how much to hedge, and in what proportions of forwards
Established in January 1999, Pine Street Capital (PSC) was a market-neutral hedge fund that specialized in the technology field, facing market risk and trying to decide whether and which way to use in order to hedge equity market risk. They choose technology sector because the partners of PSC felt that they have enough ability to evaluate this sector and specially be good at picking out-performing stock. Short-selling of NASDAQ and options hedging strategy are the two major hedging choices for PSC. Either strategy has its own advantages in different economic periods and conditions. The fund has just through one of the most volatile periods in NASDAQ 's history, and it was trying to decide whether it should continue its risk management
Nevertheless, the company Aspen needs to hedge its account. Indeed, they are in the case of economic distress: they care about their image (they need to show their robustness to their customers), they want to show the stability of the company (smoothing the account figures rather than the cash flow), and even if they need cash, they want to avoid any impact to the clients.
Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years.
Hedging can be defined as a risk management mechanism or strategy which is used to prevent the chances of incurring losses which arise as a result of fall in prices commodities or currencies. It is a technique which is majorly used by the investors in protecting their capital against the effects of the economic situations such as inflation whereby the investors invests in the high yield financial instruments or take a position to cushion them against such effects (Investopedia, 2012).
Thus, this discussion will examine scholarly articles to provide insight on historical criticisms of derivatives, why derivatives tend to be a more complicated accounting topic, implications for auditors and analysts, how FASB is making attempts to simplify derivatives, and lastly, concluding remarks.