Risk Management

In general, the calculation of an appropriate hedge for a business is based on a number of factors including:

(i) The causes of volatility to its profitability.  Thus, information is required to allow analysis of how the causes of volatility to the business’ profitability may be mitigated.  This will require an understanding of the business, its revenues (and risks to the revenue stream) and its costs (and risks that may cause a change in the cost base).

This is important because whilst there may be interest rate risk that arises from the various floating rate loans, other aspects of the business may also be sensitive (indirectly or directly) to changes in interest rates.  Thus, the hedge should seek to cover the net interest rate risk.  There may also be other risks such as currency fluctuations, commodity prices, etc.

(ii) The possibility of a change in the business model (change the manner in which business is conducted which would affect the risks), ownership structure (change in ownership, e.g. because of retirement), capital structure (change in the manner in which the business is financed, e.g. repayment of debt).

This is important because firstly, the net interest rate risk may change, therefore a hedge will need to be sufficiently flexible to allow for these  changes, and, secondly, a sale of the business or any of its assets (forced or otherwise) would result in the requirement to reduce the hedge.

(iii) All feasible hedges would then need to be assessed as to their suitability by taking into consideration, for example, the ability to understand and manage the hedge, the cost of the hedge, the tax implications of the hedge, the principals’ aversion to risk and the business’ ability to absorb any negative consequences arising from the risk.