Senior management must decide how much business risk it can absorb and how much financial risk is appropriate. Senior management also has the responsibility of selecting the best mix between financial risk and business risk.
Business risk can be defined as risk arising from uncertainty about outlays and operating cash flows, without regard to how investments are financed. Financial risk is inherent in the movement of interest and foreign-exchange rates. It also includes the risk of liquidity or the inability to refinance debt.
Corporations will always absorb some incidental exposure. It occurs in the light of competitive pressure. An example would be sales contracts denominated in, say, exotic currencies, which are difficult to hedge and often fluctuate wildly. Another more dynamic situation is the challenge of designing a pricing structure to shift some risk from the end user. For example, the price of electricity could be linked to the movement of the price of tin for a tin-producing entity. Thus, if the price of tin decreased in the marketplace, the energy supplier would lower the price of electricity to assist the tin producer in times of reduced revenue streams. During the cycle, when the price of tin is firm and/or rising, the cost of the electricity will increase accordingly.
Reducing incidental exposure will increase the predictability of results. From an analyst's perspective, reduced exposure is likely to enhance value for the company, which will be reflected in its share price. In the absence of a market view or a trend pattern developing, management should hedge against incidental exposure.
Mismanagement of incidental exposure can lead to an escalation of risk which eventually will impact on the core business exposure. Core business exposures are those that will directly impact on the business, are well known to the shareholders and often commented upon by analysts.
An airline company, for example would have the price of oil per barrel as core exposure. Management, investors and analysts alike would all be aware what impact an increase of US$2.00 per barrel would have on the cash flow projections of the airline company, should the company be unhedged.
A further illustration would be the impact of volatile interest rates on the cash flows of a highly geared/leveraged company.