How Companies Use Derivatives To Hedge Risk

If you are considering a stock investment and read the company uses derivatives to hedge some risk, should you be concerned or reassured? Warren Buffett’s stand is famous: He has attacked all derivatives, saying he and his company “view them as time bombs, both for the parties that deal in them and the economic system…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

On the other hand, the trading volume of derivatives has escalated rapidly, and non-financial companies continue to purchase and trade them in ever-greater numbers.

To help you evaluate a company’s use of derivatives for hedging risk, we’ll look at the three most common ways to use derivatives for hedging.

Key Takeaways

• When used properly, derivatives can be used by firms to help mitigate various financial risk exposures that they may be exposed to.
• Three common ways of using derivatives for hedging include foreign exchange risks, interest rate risk, and commodity or product input price risks.
• There are many other derivative uses, and new types are being invented by financial engineers all the time to meet new risk-reduction needs.

Foreign Exchange Risks

One of the more common corporate uses of derivatives is for hedging foreign currency risk, or foreign exchange risk, which is the risk a change in currency exchange rates will adversely impact business results.

Let’s consider an example of foreign currency risk with ACME Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, ACME Corp. sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000 euros worth of widgets.

When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: It can boost export sales of U.S. companies.

Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U.S. exporter when the dollar is depreciating.

The above example illustrates the “good news” event that can occur when the dollar depreciates, but a “bad news” event happens if the dollar appreciates and export sales end up being less. In the above example, we made a couple of very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event:

1. We assumed ACME Corp. manufactures its product in the U.S. and therefore incurs its inventory or production costs in dollars. If instead, ACME manufactured its German widgets in Germany, production costs would be incurred in euros. So even if dollar sales increase due to depreciation in the dollar, production costs will go up too. This effect on both sales and costs is called a natural hedge: The economics of the business provide its own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs.
2. We also assumed all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices.

Even after natural hedges and secondary effects, most multinational corporations are exposed to some form of foreign currency risk.

Now let’s illustrate a simple hedge a company like ACME might use. To minimize the effects of any USD/EUR exchange rates, ACME purchases 800 foreign exchange futures contracts against the USD/EUR exchange rate.

The value of the futures contracts will not, in practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that is, the futures rate won’t change exactly with the spot rate), but we will assume it does anyway. Each futures contract has a value equal to the gain above the $1.33 USD/EUR rate (only because ACME took this side of the futures position; the counter-party will take the opposite position).

In this example, the futures contract is a separate transaction, but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it’s not a free lunch: If the dollar were to weaken instead, the increased export sales are mitigated (partially offset) by losses on the futures contracts.

Hedging Interest Rate Risk

Companies can hedge interest rate risk in various ways. Consider a company expecting to sell a division in one year and receive a cash windfall it wants to “park” in a good risk-free investment. If the company strongly believes interest rates will drop between now and then, it could purchase (or take a long position on) a Treasury futures contract. The company is effectively locking in the future interest rate.

Here is a different example of a perfect interest rate hedge used by Johnson Controls (JCI), as noted in its 2004 annual report:

“Fair value hedges: The company [JCI] had two interest rate swaps outstanding at September 30, 2004 designated as a hedge of the fair value of a portion of fixed-rate bonds.…The change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings.”

Johnson Controls is using an interest rate swap. Before it entered into the swap, it was paying a variable interest rate on some of its bonds (e.g., a common arrangement would be to pay LIBOR plus something and to reset the rate every six months). We can illustrate these variable rate payments with a down-bar chart.

Now let’s look at the impact of the swap, illustrated below. The swap requires JCI to pay a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments (shown in the upper half of the chart below) are used to pay the pre-existing floating-rate debt.

JCI is then left only with the floating-rate debt and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. Note the annual report implies JCI has a perfect hedge: The variable-rate coupons JCI received exactly compensate for the company’s variable-rate obligations.

Commodity or Product Input Hedge

Companies depending heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases.

Monsanto produces agricultural products, herbicides, and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:

“Changes in commodity prices: Monsanto uses futures contracts to protect itself against commodity price increases…these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for, soybean and corn inventories. A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn. We also use natural gas swaps to manage energy input costs. A 10 percent decrease in price of gas would have a negative effect on the fair value of the swaps of $1 million.”

The Bottom Line

We have reviewed three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented. For example, companies can hedge their weather risk to compensate them for the extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign exchange or interest rate movements and unexpected increases in input costs.

The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for example, the company is surprised with a good-news event like a favorable interest rate move, the company (because it had to pay for the derivatives) receives less on a net basis than it would have without the hedge.

Read the original article on Investopedia.