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Risk management at Apache, Case Solution & Answer

Risk management at Apache, Case Solution 

Lastly, it could also allow the company to raise additional debt finance from various financial institutions. The hedging arrangement will provide the financers with some sort of guarantee that the management is sincere and proactive in order to protect the companyfrom negative movements in the oil prices. Moreover, the risk of the debt provider will be lower due to hedging arrangement as the earnings will be more stable which ultimately ensures the timely interest payments and capital repayment as well.

Potential downside of hedging:

Apart from the above-stated advantages and favorable implications of hedging arrangements there can be many downside implications of hedging. Firstly, it will prevent the management from favorable changes in the prices of oil, it is possible that the prices of oil increases rather than decreasing which can have an increase in the profitability of the organization.

Furthermore, the use of hedging and derivative instruments is too risky, the speculative nature of derivative instruments increases the risk of investors. Although Apache will protect itself from adverse changes in the prices of oil but it could also increase the risk potential because hedging arrangements are sometimes very dangerous when they make losses.

Importance should be given to the industry analysts regarding the use of hedging as their recommendations are based on extensive experience and knowledge of the industry. It could be possible that the cost of hedging exceeds the benefits of hedging, this is one of the biggest risks associated with hedging arrangement. The management can consider other alternative strategies and decision for the company apart from hedging which could be more beneficial for the shareholders and the company.

Inability to predict the prices accurately:

The management of Apache should arrange a hedging contract. Although this is not applicable in every case but here it would be more beneficial for the company to buy derivative instruments for hedging purpose.It can be said that the prices of oil and gas will certainly fluctuate and the nature of this fluctuation cannot be predicted by the management in advance. In this case it is better to purchase derivative instruments for hedging purpose because it will at least protect the company from adverse movements in prices of oil and gas.

Recommendation:

It is recommended that Apache should continue to use the hedging strategy in order to protect the company from the continuously reducing prices of oil and gas and to maximize the shareholder’s wealth. It is further recommended that Apache should use either costless collars or futures as a derivative instrument to protect itself and shareholders from earnings volatility.

There are some strong factors which are reducing the effectiveness of the hedging arrangements.Firstly, the new requirements of FAS 133 which states that an entity should mark to market the derivative instruments daily, Apache should give or receive money when the derivative instruments generates profit and loss respectively. In addition to this, the FAS 133 requires an entity to take all the gains and losses on derivatives to the income statement which can increase the earnings volatility by presenting loss on the derivative instrument.

However, the price of oil is expected to decrease drastically in the future which will reduce the earnings of Apache to a very low level, thus making the hedging arrangements necessary for Apache. The factors against hedging are less pervasive for Apache as compared to the benefits which are the most important parameter for the above stated recommendation.……………….

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