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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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HEDGE HORIZON

Best practice risk management programs that involve a spectrum of exposures provide guidance around hedge horizons. Depending on the nature of the exposures and their hedge markets, many companies hedge between 1 and 3 years of exposure, with a declining proportion of net exposure hedged further out in time. There are three reasons for this approach:

1. There is less certainty around the size of the exposure further into the future. Though most forecasts anticipate top-line growth and declining costs, treasurers show a pragmatic reluctance to rush out and hedge the exposures implied by these financial plans.

2. There is less certainty around expectations for hedge markets and the prices of their underlying assets further into the future. Greater consensus around nearer term rates makes nearer-term hedges seem safer and less controversial than long-dated ones, where there is a greater risk of a hedge going underwater.

3. The bid-ask spread and cost of hedge, increases with the hedge horizon. Long-dated markets are less liquid and more expensive.

In many cases, uncertainty about the future composition of cost and revenue streams, exchange rates, and thinner markets for longer-dated contracts, constrain companies’ ability to hedge far into the future.

Figure 11.2 illustrates the commonly employed laddered hedge tactic. Akin to a dollar cost averaging approach, laddering affords a practical method to reduce hedging cost and the volatility of the achieved effective rate. ...

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