Strategic Corporate Finance: Applications in Valuation and Capital Structure

OPTIONS VERSUS FORWARDS

Best practice companies incorporate a combination of operational process controls, natural hedges, and capital structure solutions within their enterprise risk management (ERM) programs, and they employ a combination of financial hedging tools (e.g., options, swaps, and forwards) to match their objectives, constraints, views, exposures, and risk preferences.

The pros and cons of each tool include its cost and degree of downside protection and its potential for upside, risk profile and behavior in extreme outcomes, accounting treatment, counterparty risk, ease of execution, and compatibility with control processes.

Best practice hedging programs combine symmetric and asymmetric strategies to enhance overall effectiveness. Hedging exposures using futures or forward contracts are examples of symmetric hedging, where outcomes are locked in and downside protection is purchased at the implicit cost of upside exposure (i.e., eliminating exposure to the upside and the downside). Asymmetric hedging is achieved through the use of options, where downside protection is purchased at an explicit cash cost and upside exposure is retained.

For example, a large diversified industrial is a well-known, conservative, commodity-driven business with exposure to emerging markets through diverse geographic location of assets and end markets. Most of their commodity hedging is performed with respect to gold prices. The company largely hedges its interest rate and currency exposure ...