Real Hedge Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The meaning of a real hedge varies with the context in which it is used. A real hedge involves taking of positions by investors to alter their exposure to risk. The term real hedge is most widely used in the risk management literature to mean a hedge based on real options. A hedge is any device used by an investor to reduce the risk of a given investment. This can take the form of the purchase of any asset or array of assets to issue against fluctuations in wealth from alternative sources.

The distinguishing feature then of a real hedge is the kind of assets used in such a hedge portfolio or collection of hedge portfolios. If the hedge portfolio consists of only financial assets, then this is a financial hedge whereby the holder acquires the right to buy or sell a traded asset such as a stock. For example, a forward foreign exchange contract can be used by a company based in Europe that exports its products to the United States and is exposed to the risk of changes in exchange rates between the euro and the U.S. dollar. In a case such as this, if the firm exports goods worth US$10 million annually and there transpires a 10 percent depreciation of the U.S. dollar against the euro, it stands to lose €10 million per annum. The firm can sell U.S. dollars forward, thereby using a financial hedge to offset its exposure to foreign exchange risk in the short run. Considering long-run horizons, however, if the underlying transactions do not materialize because of unanticipated changes in business conditions, the intended financial hedge can be transformed into a form of financial speculation. A real hedge, based on real options, is more suitable in the long run.

A real option is the right to take a specific business decision such as making or not making a capital investment. An important distinction between real and financial options is that the underlying assets on which real options are based are not traded in competitive markets. This distinction thus also applies with respect to real hedges and financial hedges. Real options give an investor the flexibility to choose the most attractive alternatives subsequent to the availability of new information and thereby add value to investment opportunities. Real options are almost always investment specific. In the example above, the European-based firm has, at least in theory, the real option of starting up production in the United States. This specificity makes it difficult to describe a general theory of real options on which real hedging is based. There are, nonetheless, three main types of options that are commonly encountered in the literature. These are the option to delay an investment opportunity, the option to grow, and the option to abandon an investment opportunity. The option to delay an investment opportunity gives the firm a chance to choose an optimal time to commit to an investment and thus add value to it. The growth option entails a firm having a real option to invest in the future, especially when market conditions are better than expected. The growth options can involve expanding the capacity of an existing product line, going into new geographic markets, or adding new products.

The abandonment option is the option to walk away from a project. In the example above, the European based manager does not have to be restricted to a financial hedge. The company can use a real option of shutting down production in Europe and starting production in the United States. This is subject to absence of barriers to entry in the U.S. market, if the firm does not have any facilities in the United States initially.

From this perspective of real hedging, the decision as to whether a financial hedge or real hedge should be adopted depends on whether the described level of risk is for the short run or part of a long-term problem. Empirical studies show a preference for financial hedges in the short run, while real hedges are more commonly used for the longer-term risk strategies. The decision also hinges on the costs and benefits of hedging, it being the case that the real cost of hedging is what the firm incurs by not hedging.

Bibliography:

Tom Aabo and Betty J. Simkins, “Interaction Between Real Options and Financial Hedging: Fact or Fiction in Managerial Decision-Making,” Review of Financial Economics (v.14, 2005);
Udo Broll and Jack E. Wahl, Export Production, Hedging Exchange Rate Risk: The Duopoly Case (Technische Universität Dresden, 2008);
Björn Döhring, Hedging and Invoicing Strategies to Reduce Exchange Rate Exposure: A Euro-Area Perspective (European Commission, Directorate-General for Economic and Financial Affairs, 2008);
John C. Hull, Options, Futures and Other Derivative Securities (Pearson Prentice Hall, 2009);
Kit Pong Wong, “The Effects of Abandonment Options on Operating Leverage and Forward Hedging,” International Review of Economics and Finance (v.15, 2006).

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