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

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HEDGE RATIO

Reducing exposure mitigates volatility but only to a certain level. We have found that hedging an exposure exhibits a characteristic of diminished marginal returns, implying that full hedging is neither beneficial nor economic. Again, this depends on the company, its exposures, and its markets, but most hedges do not exceed 80 percent (i.e., 80 percent hedge ratio) of near-term exposure, about 50 percent 1 year forward and about 30 percent 2 years forward. Longer-term hedges (e.g., 3 years) tend to be small (e.g., 10 percent hedge ratio), out-of-the-money (i.e., option-based): positions that provide a form of disaster insurance and a toehold on a larger hedge as the exposure gets closer in time.

Just as companies are opportunistic in issuing or buying back stock, so will they be with risk management. Unfortunately, as is often the case with interest rate management, this can lead to practice that is too ad hoc and unsystematic to be able to be documented or articulated as any form of financial policy. From a corporate governance perspective, Boards of Directors will recognize this is a process in need of objectives, constraints, and tolerance ranges for better control.

As outlined for the case of interest rate management in an earlier chapter, a dynamic hedging strategy that incorporates market information can significantly reduce cost and risk. Hedge ratios may be managed to preset guidelines but not constant ones; they must be managed dynamically in accordance with ...

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