9.2 Hedging with Derivatives

Derivatives are financial tools that help companies manage risks like price fluctuations, interest rates, and currency changes. They're contracts that derive value from underlying assets, allowing businesses to transfer specific risks to willing parties.

Companies use derivatives to hedge against potential losses. For example, an airline might use oil futures to protect against rising fuel costs. This strategy helps lock in prices and reduce uncertainty, making financial planning easier and more stable.

Derivatives for Hedging

Definition and Purpose of Derivatives

Top images from around the web for Definition and Purpose of Derivatives

• 

  Derivatives Market $280 Trillion – Is It Really A Time Bomb? View original

  Is this image relevant?

• 

  01. The Significance of Derivatives in the Management - Research leap View original

  Is this image relevant?

• 

  Derivatives Market $280 Trillion – Is It Really A Time Bomb? View original

  Is this image relevant?

• 

  01. The Significance of Derivatives in the Management - Research leap View original

  Is this image relevant?

1 of 2

Top images from around the web for Definition and Purpose of Derivatives

• 

  Derivatives Market $280 Trillion – Is It Really A Time Bomb? View original

  Is this image relevant?

• 

  01. The Significance of Derivatives in the Management - Research leap View original

  Is this image relevant?

• 

  Derivatives Market $280 Trillion – Is It Really A Time Bomb? View original

  Is this image relevant?

• 

  01. The Significance of Derivatives in the Management - Research leap View original

  Is this image relevant?

1 of 2

• Derivatives are financial instruments whose value is derived from an underlying asset, rate, index, or event
• They are contracts between two parties that specify conditions under which payments are to be made between the parties
• Derivatives allow companies to transfer specific risks to other parties who are willing to bear those risks, enabling more effective risk management and potentially reducing the overall cost of managing risk
• Common risks that can be hedged with derivatives include commodity price risk (oil prices for airlines), interest rate risk (variable rate debt), credit risk (customer defaults), and foreign exchange risk (sales in foreign currencies)

Role of Derivatives in Hedging

• Hedging is a risk management strategy that involves taking an offsetting position in a related security or derivative to reduce the risk of adverse price movements in an existing position
• For example, a company with a large oil storage inventory may sell oil futures contracts to hedge against a decline in oil prices that would reduce the value of their inventory
• By taking an offsetting position, the company can lock in a price for their inventory and protect against potential losses from falling prices
• Derivatives provide a flexible and efficient way to hedge specific risks without having to directly buy or sell the underlying asset or commodity

Types of Derivatives

Forward and Futures Contracts

• Forward contracts are non-standardized agreements between two parties to buy or sell an asset at a specified future time at a price agreed upon today
• They are often used to hedge foreign exchange risk (locking in a future exchange rate) or commodity price risk (agreeing to buy or sell a commodity at a fixed price in the future)
• Futures contracts are standardized, exchange-traded contracts to buy or sell an asset on or before a future date at a price specified today
• They are marked to market daily, meaning gains and losses are settled each day, and can be used to hedge commodity price risk (oil, agricultural products) or financial market risk (interest rates, stock indexes)

Swaps

• Swaps are agreements between two parties to exchange cash flows in the future according to a prearranged formula
• Interest rate swaps involve exchanging floating rate payments for fixed rate payments or vice versa, effectively transforming the nature of liabilities or assets to better match risk preferences or exposures
• Currency swaps involve exchanging principal and interest payments in one currency for principal and interest payments in another currency, helping to hedge foreign exchange risk
• For example, a company with a floating rate loan may enter into a swap to pay a fixed rate and receive a floating rate to hedge against rising interest rates

Options

• Options are contracts that give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a pre-determined price (strike price) on or before a certain date
• They can be used to hedge downside risk while maintaining upside potential, for example buying put options on a stock you own allows you to limit losses to the strike price
• Selling covered call options on a stock you own can provide additional income and partial hedge against a price decline, but limits upside to the strike price
• Options on physical commodities, futures contracts, interest rates, and currencies are commonly used for hedging purposes

Hedging Strategies

Commodity Price Risk

• To hedge commodity price risk, a company can take a position in a futures or forward contract opposite to their physical position in the commodity
• For example, an airline that needs to buy jet fuel in the future may buy crude oil futures contracts to lock in the price and protect against rising oil prices that would increase their fuel costs
• A mining company that will be selling copper at a future date may sell copper futures to lock in a price and hedge against falling copper prices that would reduce their revenues
• Commodity processors like food companies or refiners often hedge to lock in their profit margins by simultaneously buying futures on their raw material inputs and selling futures on their finished product outputs

Foreign Exchange Risk

• To hedge foreign exchange risk, a company can use a currency forward or option to lock in an exchange rate for a future transaction
• For example, a U.S. company expecting to receive a €1 million payment in 6 months could sell a €1M/$ forward contract to lock in the amount of dollars they will receive, eliminating exchange rate risk
• Alternatively, the company could buy a €1M/$ put option, which would give them the right to sell euros at a predetermined exchange rate, providing protection against the euro weakening while allowing them to benefit if the euro strengthens
• Companies with ongoing foreign exchange exposures, like a U.S. company with significant sales in Europe, may implement a rolling hedge program, continuously hedging a certain portion of their expected foreign currency cash flows

Interest Rate Risk

• To hedge interest rate risk on future borrowing, a company could enter into a forward rate agreement that locks in a borrowing rate for a specified period in the future
• Alternatively, the company could buy an interest rate cap option, which would compensate the company if interest rates rise above the strike rate, or an interest rate floor option, which would compensate the company if interest rates fall below the strike rate
• To hedge outstanding floating rate debt, a company could enter into an interest rate swap to pay a fixed rate and receive a floating rate, effectively converting the debt to a fixed rate obligation
• For example, a company with a $100 million floating rate bank loan may enter into a 5-year swap to pay a 3% fixed rate and receive LIBOR to hedge against rising interest rates

Credit Risk

• Credit derivatives like credit default swaps (CDS) can be used to hedge against a borrower's credit risk by transferring the default risk to a counterparty for a fee
• For example, a bank that has made a $10 million loan to a company may buy a CDS that would pay off the loan if the company defaults, effectively insuring against credit losses
• CDS can also be used to hedge against the credit risk of bonds the investor holds or to speculate on changes in the creditworthiness of a company
• By buying and selling CDS protection, banks and investors can manage their credit risk exposures and free up capital that would otherwise be needed to cover potential losses

Effectiveness of Derivatives

Measuring Hedge Effectiveness

• Hedge effectiveness refers to the degree to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item attributable to the hedged risk
• Highly effective hedges minimize income statement volatility by offsetting gains and losses on the hedged item and hedging instrument
• To qualify for hedge accounting treatment, which allows deferral of gains and losses on the hedging instrument until the hedged transaction occurs, hedges must be documented as such at inception and demonstrated to be highly effective on an ongoing basis
• Hedge effectiveness is typically measured by comparing the change in value of the hedging instrument to the change in value of the hedged item, with a ratio between 80-125% considered highly effective

Basis Risk

• Basis risk is the risk that the value of the hedging instrument may not move in line with the value of the underlying hedged item, leading to imperfect offsetting
• Basis risk can arise from differences in the grade or location of the physical commodity vs. the standardized futures contract used to hedge it
• For example, a company hedging jet fuel with crude oil futures may be exposed to basis risk if the price of jet fuel doesn't move in lockstep with crude oil due to changes in refining margins
• Basis risk can also arise from differences in the timing of the hedged transaction vs. the maturity of the hedging instrument or from a mismatch in the underlying interest rates or currencies
• Basis risk is inherent in many hedging strategies and can limit the effectiveness of the hedge in offsetting the underlying risk exposure

Counterparty Risk

• Derivatives involve taking on counterparty risk - the risk that the other party to the contract may not fulfill its obligations
• For example, in an interest rate swap, if the counterparty supposed to make floating rate payments defaults, the company would still be obligated to make the fixed rate payments but would not receive the offsetting floating rate payments
• Counterparty risk can be mitigated by transacting through a central clearinghouse that acts as an intermediary between buyers and sellers and requires margin to be posted to cover potential losses
• Counterparty risk can also be managed by requiring collateral to be posted by the counterparty, setting exposure limits, and diversifying across multiple counterparties with strong credit ratings
• The failure of large derivatives counterparties like Lehman Brothers during the financial crisis underscored the importance of managing counterparty risk in derivatives transactions

Accounting and Disclosure

• Derivatives accounting rules are complex and can lead to income statement volatility if hedges are not perfectly effective or do not qualify for hedge accounting treatment
• To qualify for hedge accounting, hedges must be highly effective and properly documented, with ineffectiveness recognized in earnings each period
• Companies must disclose their derivatives positions and hedging strategies in the footnotes to their financial statements, including notional amounts, fair values, and gains and losses
• Designing and documenting hedging strategies to qualify for hedge accounting and meet disclosure requirements can be operationally burdensome and require sophisticated financial reporting systems and controls
• Proposed changes to hedge accounting rules aim to better align the accounting with companies' risk management strategies and provide more flexibility in qualifying for hedge accounting

Liquidity and Transparency

• Exchange-traded derivatives like futures and options are standardized contracts that trade on regulated exchanges, providing transparency and liquidity
• Prices are publicly disseminated and contracts can easily be offset by entering into an opposite trade, making them useful for hedging
• Over-the-counter (OTC) derivatives like forwards and swaps are customized contracts negotiated bilaterally between counterparties, lacking the transparency and liquidity of exchange-traded derivatives
• OTC derivatives may have more favorable terms and allow more precise hedging, but pricing and valuation can be more subjective and the market may be less deep, especially in times of financial stress
• Efforts to improve transparency and reduce systemic risk in OTC derivatives markets have included mandatory central clearing, trade reporting, and margin requirements for non-cleared swaps
• Despite these efforts, a lack of liquidity in OTC derivatives markets can still pose challenges in executing and unwinding hedges, particularly for less common or longer-dated instruments