Ricardo Colón, an analyst in the investment management division of a financial services firm, is developing an earnings forecast for a local oil services company. The company’s income is closely linked to the price of oil. Furthermore, the company derives the majority of its income from sales to the United States. The economy of the company’s home country depends significantly on export oil sales to the United States. As a result, movements in world oil prices in US dollar terms and the US dollar value of the home country’s currency are strongly positively correlated. A decline in oil prices would reduce the company’s sales in US dollar terms, all else being equal. On the other hand, the appreciation of the home country’s currency relative to the US dollar would reduce the company’s sales in terms of the home currency.
According to Colón’s research, Raúl Rodriguez, the company’s chief risk officer, has made the following statement:
“The company has rejected hedging the market risk of a decline in oil prices by selling oil futures and hedging the currency risk of a depreciation of the US dollar relative to our home currency by buying home currency futures in US markets. We have decided that a more effective risk management strategy for our company is to not hedge either market risk or currency risk.”
Required:
State whether the company’s decision to not hedge market risk was correct. Justify your answer with one reason.
Hint: there is a positive correlation between world oil prices in US dollar terms and US dollar value of the home currency, indicating if the price of oil were to increase, the home currency should appreciate against the US dollars and if the price of oil were to decrease, the home currency should depreciate.
State whether the company’s decision to not hedge currency risk was correct. Justify your answer with one reason.