Derivatives Hedging::Corporate Uses!!

If you are considering a stock investment and you read that 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" (2003 Berkshire Hathaway Annual Report).
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. Consider the Chicago Mercantile Exchange, which is the largest exchange for futures contracts in the United States. As of November 2004, the average daily volume of futures contracts reached 3.2 million, up a stunning 40% from the previous year. In the same month, foreign-exchange futures set a new record for single-day volume, reaching more than half-a-million contracts, with a notional value of over $72 billion.

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.

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 adversely impacts 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, or one euro translates into more dollars, 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 that 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 would go up too! This effect on both sales and costs is called a natural hedge: the economics of the business provide their 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 that 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 that 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, somebody - 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, then 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 that expects to sell a division in one year and at that time to receive a cash windfall that it wants to "park" in a good risk-free investment. If the company strongly believes that 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, 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. (JCI 10K, 11/30/04 Notes to Financial Statements)

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. (For example, a common arrangement would be to pay LIBOR plus something and to reset the rate every six months).

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. And again, note the annual report implies JCI has a "perfect hedge": The variable-rate coupons that JCI received exactly compensates for the company's variable-rate obligations.

Commodity or Product Input Hedge
Companies that depend 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 - although at the start of 2004 one major airline mistakenly settled (eliminating) all of its crude-oil hedges: a costly decision ahead of the surge in oil prices.

Monsanto (ticker: MON) 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. (Monsanto 10K, 11/04/04 Notes to Financial Statements)

Conclusion
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 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.

Commodities Hedging::Corporates

The Hedging Decision
The issue of whether or not to hedge risk continues to baffle many corporations. At the heart of the confusion are misconceptions about risk, concerns about the cost of hedging, and fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools and strategies compounds this confusion. Corporate risk managers also face the difficult challenge of getting hedging tools (i.e., derivatives) approved by the company's board of directors. The purpose of this article is to clarify both some of the basic misconceptions surrounding the issue of risk as well as the tools and strategies used to manage it.

The Challenge
An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to transform unacceptable risks into an acceptable form. The key challenge for the corporate risk manager is to determine the risks the company is willing to bear and the ones it wishes to transform by hedging. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging.

This article will outline seven steps designed to help risk managers determine whether or not their companies stand to benefit from a hedging program.

STEP 1: Identify The Risks
Before management can begin to make any decisions about hedging, it must first identify all of the risks to which the corporation is exposed. These risks will generally fall into two categories: operating risk and financial risk. For most non-financial organizations, operating risk is the risk associated with manufacturing and marketing activities. A computer manufacturer, for example, is exposed to the operating risk that a competitor will introduce a technologically superior product which takes market share away from its leading model. In general, operating risks cannot be hedged because they are not traded.

The second type of risk, financial risk, is the risk a corporation faces due to its exposure to market factors such as interest rates, foreign exchange rates and commodity and stock prices. Financial risks, for the most part, can be hedged due to the existence of large, efficient markets through which these risks can be transferred.

In determining which risks to hedge, the risk manager needs to distinguish between the risks the company is paid to take and the ones it is not. Most companies will find they are rewarded for taking risks associated with their primary business activities such as product development, manufacturing and marketing. For example, a computer manufacturer will be rewarded (i.e., its stock price will appreciate) if it develops a technologically superior product or for implementing a successful marketing strategy.

Most corporations, however, will find they are not rewarded for taking risks which are not central to their basic business (i.e., interest rate, exchange rate, and commodity price risk). The computer manufacturer in the previous example is unlikely to see its stock price appreciate just because it made a successful bet on the dollar/yen exchange rate.

Another critical factor to consider when determining which risks to hedge is the materiality of the potential loss that might occur if the exposure is not hedged. As noted previously, a corporation's optimal risk profile balances the benefits of protection against the costs of hedging. Unless the potential loss is material (i.e., large enough to severely impact the corporation's earnings) the benefits of hedging may not outweigh the costs, and the corporation may be better off not hedging.

STEP 2: Distinguish Between Hedging and Speculating
One reason corporate risk managers are sometimes reluctant to hedge is because they associate the use of hedging tools with speculation. They believe hedging with derivatives introduces additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks.

Financial risks - regardless of whether or not they are managed - exist in every business. The manager who opts not to hedge is betting that the markets will either remain static or move in his favor. For example, a U.S. computer manufacturer with French franc receivables that decides to not hedge its exposure to the French franc is speculating that the value of the French franc relative to the U.S. dollar will either remain stable or appreciate. In the process, the manufacturer is leaving itself exposed to the risk that the French franc will depreciate relative to the U.S. dollar and hurt the company's revenues.

A reason some managers choose not to hedge, thereby exposing their companies to additional risk, is that not hedging often goes unnoticed by the company's board of directors. Conversely, hedging strategies designed to reduce risk often receive a great deal of scrutiny. Corporate risk managers who wish to use hedging techniques to improve their company's risk profile must educate their board of directors about the risks the company is naturally exposed to when it does not hedge.

STEP 3: Evaluate the Costs of Hedging in Light of the Costs of not Hedging
The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company stands to suffer if market factors, such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative to the potential loss.

In other cases, derivative transactions are substitutes for implementing a financing strategy using a traditional method. For example, a corporation may combine a floating-rate bank borrowing with a floating-to-fixed-rate swap as an alternative to issuing fixed-rate debt. Similarly, a manufacturer may combine the spot purchase of a commodity with a floating-to-fixed swap instead of buying the commodity and storing it. In most cases where derivative strategies are used as substitutes for traditional transactions, it is because they are cheaper. Derivatives tend to be cheaper because of the lower transaction costs that exist in highly liquid forward and options markets.

STEP 4: Use the Right Measuring Stick to Evaluate Hedge Performance
Another reason for not hedging often cited by corporate risk managers is the fear of reporting a loss on a derivative transaction. This fear reflects widespread confusion over the proper benchmark to use in evaluating the performance of a hedge. The key to properly evaluating the performance of all derivative transactions, including hedges, lies in establishing appropriate goals at the onset.

As noted previously, many derivative transactions are substitutes for traditional transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond. Regardless of market conditions, the swap's cash flows will mirror the bond's. Thus, any money lost on the swap would have been lost if the corporation had issued a bond instead. Only if the swap's performance is evaluated in light of management's original objective (i.e., to duplicate the cash flows of the bond) will it become clear whether or not the swap was successful.

STEP 5: Don't Base Your Hedge Program On Your Market View
Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices.

STEP 6: Understand Your Hedging Tools
A final factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options, which comprise the following basic building blocks:

Forwards Options
- Swaps - Caps
- Futures - Floors
- FRAs - Puts
- Locks - Calls
- Swaptions

The manager who understands these will be able to understand more complex structures which are simply combinations of the two basic instruments.

STEP 7: Establish A System of Controls
As is true of all other financial activities, a hedging program requires a system of internal policies, procedures and controls to ensure that it is used properly. The system, often documented in a hedging policy, establishes, among other things, the names of the managers who are authorized to enter into hedges; the managers who must approve trades; and the managers who must receive trade confirmations. The hedging policy may also define the purposes for which hedges can and cannot be used. For example, it might state that the corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes. It may also set limits on the notional value of hedges that may be outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the company's board of directors are aware of the hedging activities used by the corporation's risk managers and that all risks are properly accounted for and managed.

Conclusion
A well-designed hedging program reduces both risks and costs. Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimizing the risks that are not central to the basic business. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing earnings.