How Companies Use Derivatives to Hedge Risk

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How Companies Use Derivatives to Hedge Risk

Should you be alarmed or comforted if you are contemplating a stock purchase and learn that the firm employs derivatives to hedge some risk? Warren Buffett’s stance on derivatives is well-known: he and his firm “see them as time bombs, both for the parties who trade in them and the economic system…derivatives are financial weapons of mass destruction, bearing hazards that, although presently latent, are potentially fatal.”

On the other hand, the trading volume of derivatives has quickly increased, and non-financial firms continue to buy and trade them in ever-increasing quantities.

We’ll look at the three most frequent methods to utilize derivatives for hedging risk to help you assess a company’s usage of derivatives for hedging risk.

Key Takeaways

  • Derivatives, when handled correctly, may assist organizations manage different financial risk exposures to which they may be exposed.
  • Foreign currency risks, interest rate risks, and commodity or product input price risks are three typical ways derivatives are used for hedging.
  • There are several additional derivative applications, and new kinds are constantly being developed by financial engineers to fulfill new risk-reduction requirements.

Foreign Exchange Risks

One of the most typical corporate applications of derivatives is to hedge foreigncurrency risk, also known as foreign exchange risk, which is the risk that a change in currency exchange rates may negatively influence company outcomes.

Consider ACME Corporation, a fictitious US-based corporation that sells widgets in Germany, as an illustration of foreign currency risk. Throughout the year, ACME Corp offers 100 widgets for 10 euros each. As a result, we always assume that ACME sells 1,000 euros worth of widgets.

Image by Sabrina Jiang © Investopedia2021

When the dollar-to-euro exchange rate rises from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, indicating that the dollar is weakening. As the value of the dollar falls, the same number of widgets sold results in higher dollar sales. This indicates how a weaker dollar isn’t always a negative thing: it may enhance US firms’ overseas sales.

Alternatively, ACME might decrease its pricing internationally, which would not impact dollar sales due to the sinking currency; this is another option accessible to a US exporter while the dollar is declining.

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The above example depicts a “good news” event that may occur when the dollar depreciates, but a “bad news” event occurs when the currency rises and export sales fall. In the above example, we made two critical simplifying assumptions that influence whether a dollar depreciation is a positive or negative event:

  1. We assumed that ACME Corp. produces its goods in the United States and hence incurs inventory or manufacturing expenses in dollars. If ACME produced its German widgets in Germany, the manufacturing expenses would be incurred in euros. As a result, even if dollar sales increase owing to currency depreciation, manufacturing costs will rise as well. This influence on both sales and expenses is known as a natural hedge: the business’s economics offer its own hedging mechanism. Greater manufacturing costs are anticipated to offset higher export sales (as a consequence of the euro being converted into dollars).
  2. We also assumed that everything else was equal, which is not always the case. For example, we overlooked any secondary impacts of inflation and whether ACME’s pricing may be adjusted.

Even with natural hedges and secondary impacts, most multinational firms face foreign currency risk.

Now consider a basic hedge that a corporation like ACME may use. ACME acquires 800 foreign currency futures contracts against the USD/EUR exchange rate to mitigate the consequences of any USD/EUR exchange rates.

In actuality, the value of futures contracts will not correlate precisely on a 1:1 basis with a change in the current exchange rate (that is, the futures rate will not change exactly with the spot rate), but we will pretend it does nevertheless. Each futures contract is worth the amount gained over the $1.33 USD/EUR rate (only because ACME took this side of the futures position;the counter-partywill take the opposite position).

Image by Sabrina Jiang © Investopedia2021

The futures contract is a distinct transaction in this case, but it is structured to have an inverse connection with the currency exchange effect, making it a good hedge. Of course, it’s not a free lunch: if the dollar falls instead, the higher export sales are countered (mostly offset) by futures contract losses.

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Hedging Interest Rate Risk

Companies may manage interest rate risk in a variety of ways. Consider a corporation that expects to sell a division in a year and get a financial windfall that it wishes to “park” in a safe investment. If the corporation is certain that interest rates will fall between now and then, it may buy (or take a long position in) a Treasury futures contract. The corporation has successfully secured the future interest rate.

Johnson Controls (JCI) offered a different example of a perfect interest rate hedging in its 2004 annual report:

Fair value hedges: The company [JCI] had two interest rate swaps outstanding on 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.

An interest rate swap is being used by Johnson Controls. It was paying a variable interest rate on certain of its bonds before to entering into the exchange (e.g., a common arrangement would be to pay LIBOR plus something and to reset the rate every six months).A down-bar chart may help us see these variable rate payments.

Image by Sabrina Jiang © Investopedia2021

Now consider the effect of the transaction, as represented below. JCI is required to pay a set rate of interest while receiving floating-rate payments under the swap. The obtained floating-rate payments (seen in the top half of the chart below) are used to pay down the previously incurred floating-rate debt.

Image by Sabrina Jiang © Investopedia2021

JCI is thus left with just the floating-rate debt and has so converted a variable-rate commitment into a fixed-rate obligation via the use of a derivative. The annual report suggests that JCI has a perfect hedge: the variable-rate coupons received by the firm perfectly compensate for the company’s variable-rate commitments.

Commodity or Product Input Hedge

Companies that rely substantially on raw-material inputs or commodities are susceptible to price changes, sometimes dramatically so. Jet fuel is used extensively by airlines, for example. Historically, most airlines have devoted considerable thought to hedging against crude-oil price rises.

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Monsanto manufactures agricultural goods, pesticides, and biotech items. It employs futures contracts to protect itself from increases in the price 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 the price of gas would have a negative effect on the fair value of the swaps of $1 million.

The Bottom Line

We looked at three of the most common methods of company hedging using derivatives. There are several additional derivative applications, and new varieties are constantly being developed. Companies, for example, might hedge their weather risk to compensate for the additional expense of an unusually hot or cold season. For the most part, the derivatives we examined are not speculative for the corporation. They assist in protecting the firm against unpredictable occurrences such as unfavourable currency or interest rate fluctuations and unexpected increases in input prices.

The speculator is the investor on the opposing side of the derivative deal. However, these derivatives are never free. Even if the corporation is surprised by a good-news occurrence, such as a positive interest rate shift, the company earns less on a net basis than it would have received without the hedge.

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