In an earlier post we discussed one of several reasons why companies tend to focus their hedges on short-term cash flows, leaving long-term cash flows unhedged. There we pointed out that the right response over the long-run to fluctuating prices and other risk factors, is changes in the operations and investments of the firm in order to re-maximize profits in light of the new competitive conditions. But there are several distinct reasons for the practice, and that was only one of them.
Another reason why firms concentrate their financial hedges on short term cash flows has to do with uncertainty about the nature of the exposure at longer time horizons. Competitive exposures are very complicated, and involve many, many risk factors. We oftentimes focus on a single specific risk factor and quantify the exposure in very simplistic models. This is necessary if we are going to implement a financial hedge. For example, the airline needs to buy or sell futures contracts on a specific type of fuel delivered at a specific location on a specific date. To design that hedge we try to quantify the airline’s exposure measured in terms of the commodity represented by that specific fuel. But this focus on a single risk factor and exposure measured using recent data is only valid for very short horizons. The correlation between the futures price for that specific fuel and the airline’s actual cash flow may not hold at some distant date. All sorts of changes could undermine the validity of extrapolating that correlation. Some of these may be changes in the industry’s competitive dynamics, some may be in the types of fuels that are used by the airlines. For example, if bio-fuels gradually replace fossil-based fuels in jets, then the correlation between crude oil prices and the airline’s exposure will almost certainly change. The higher the uncertainty about the industry dynamics, the less a firm should commit to hedge, because it knows less how much it should hedge. And the essence of uncertainty is that it increases just with the length of time into the future. Prudence (i.e., sound risk management) indicates that it is not right to make commitments – either firm or contingent – when ignorance pervades.