How businesses are hedging with derivatives

In the realm of corporate finance, hedging is a method employed to mitigate risks, often those that are not insurable or budgetable. The primary risks where hedging proves to be a valuable technique include:

1. Interest Rate Fluctuations: This pertains to the increased cost of borrowing or diminished returns on savings when interest rates change unfavorably.
2. Unfavorable Currency Fluctuations: These can lead to diminished export values or increased import costs.
3. Escalating Raw Material Expenses: Factors such as a poor crop or natural/man-made disasters causing reduced market supply, or heightened demand from other consumers leading to price hikes.

How Does Hedging Operate? In financial markets, hedging is predominantly accomplished through the use of derivatives. It’s worth noting that hedging, particularly via financial derivatives, has its detractors, as some perceive derivative products as a threat to market stability, a sentiment exacerbated by the 2008 financial crisis linked to derivative products tied to US mortgages. Nonetheless, we will focus on the types of derivatives utilized to hedge against the three previously mentioned risks. Hedging Against Interest Rate Risk: For simplicity, let’s consider a hypothetical company, DeltaCorp, which is obligated to repay a £1 million loan along with a fixed interest rate of 1.7% within a year. On the other hand, Sigma Group holds a loan of similar size with a variable interest rate based on six-month LIBOR at 0.5% plus 1%. Sigma anticipates an impending increase in interest rates over the next year and aims to mitigate its exposure to this risk. Delta, on the other hand, believes that the interest rate environment will remain favorable and is willing to take the risk. In an interest rate swap agreement, Delta still pays its initial lender the 1.7% fixed rate interest (£17,000), and Sigma still pays the current floating rate (0.5% + 1%, totaling £15,000) to its original lender. However, under the terms of the swap, Delta essentially owes Sigma £15,000, while Sigma owes Delta £17,000. This partially offsets the amounts, resulting in Sigma receiving £2,000 from Delta. Should Sigma’s prediction materialize, and interest rates indeed rise over the year, both parties fulfill their interest obligations to their initial lenders. Still, according to the swap agreement, Delta would then owe Sigma the new floating rate amount (£19,000), whereas Sigma would still owe Delta £17,000. This leaves Sigma with a net gain of £2,000.

Hedging Against Currency Risk: Companies conducting international operations and repatriating foreign earnings into their domestic currency face the risk of currency fluctuations that may adversely affect their profits. Companies have the choice of employing futures or forwards to hedge against currency risk. Here, we’ll concentrate on the more commonly used futures market. For instance, DeltaCorp, which sells products in euros to a French customer, is concerned about the volatility of the sterling/euro (£/€) exchange rate. To safeguard against potential losses due to a strengthening pound, DeltaCorp purchases £100,000 worth of euro futures at a strike price of €1.15. This ensures that, regardless of the exchange rate at the time of invoice settlement, DeltaCorp will receive the expected amount for its products. Hedging Against Rising Materials Costs: Similar to currency hedging, companies may opt to secure material purchases at a specific price to avoid purchasing at spot prices during periods of escalating costs. For example, DeltaCorp aims to acquire aluminium at a price no higher than £1,500 per tonne. The futures market suggests that it can purchase at £1,450 per tonne in five months. Thus, DeltaCorp enters a futures contract to secure the purchase of five tonnes at £1,450 per tonne. Even if a supply disruption causes the price to soar to £1,600 per tonne, DeltaCorp is protected by the contract, ensuring its product pricing remains unaffected. Incorporating effective risk management, companies can leverage the available tools to hedge against currency, interest rate, and commodity risks. This strategic approach can render them more efficient, adaptable, and responsive to competitive pressures, as exemplified by the long-standing practice of airlines hedging fuel prices. However, it’s essential to be cognizant of associated costs, such as commissions, transaction fees, and contract termination charges, when utilizing derivatives for hedging purposes. Additionally, prudent risk management is crucial to prevent potentially significant losses in case of unfavorable outcomes, as demonstrated by JP Morgan’s $2 billion misstep in the credit default swaps market in 2012.

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