If you’re considering a stock investment and read that a company uses derivatives to hedge some risk, should you be concerned or reassured? Warren Buffett is famous for his stance on derivatives. 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.”1
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.2 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 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 that 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: 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 this case, higher export sales resulting from the euro being translated into dollars are likely mitigated by higher production costs. We assumed all other things are equal, but often they aren’t. For example, we ignored 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. ACME purchases 800 foreign exchange futures contracts against the USD/EUR exchange rate to minimize the effects of any exchange rates. The value of futures contracts won’t correspond exactly 1:1 with a change in the current exchange rate, but we assume it does. Each futures contract has a value equal to the gain above the $1.33 USD/EUR rate. The futures contract is a separate transaction but designed to have an inverse relationship with the currency exchange impact, so it’s a decent hedge. However, if the dollar weakens instead, increased export sales are mitigated 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 to park in a good risk-free investment. If the company believes interest rates will drop, it could purchase a Treasury futures contract to lock in the future interest rate. Here’s an example of a perfect interest rate hedge used by Johnson Controls (JCI). As noted in its 2004 annual report, JCI had two interest rate swaps outstanding 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. JCI was paying a variable interest rate on some of its bonds. Now with the swap, JCI pays a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments are used to pay the pre-existing floating-rate debt. JCI is left only with the floating-rate debt and has converted a variable-rate obligation into a fixed-rate obligation with the addition of a derivative.Companies often use derivatives to hedge risks. Let’s look at some examples. Note that 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 is another way. Companies relying heavily on raw-material inputs or commodities are sensitive to price changes. For instance, airlines consume a lot of jet fuel and historically, most airlines consider hedging against crude-oil price increases. Monsanto, which produces agricultural products, herbicides, and biotech-related products, uses futures contracts to hedge against price increases 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.’ We have reviewed three popular types of corporate hedging with derivatives. There are many other uses and new types are being invented. For example, companies can hedge weather risk. The derivatives reviewed are not generally speculative for the company. They protect the company from unanticipated events like adverse foreign exchange or interest rate movements and unexpected input cost increases. The investor on the other side of the derivative transaction is the speculator. However, these derivatives are not free. Even if the company gets a good-news event like a favorable interest rate move, due to paying for the derivatives, the company receives less on a net basis than without the hedge.