How companies are using derivatives to hedge

Hedging, in terms of corporate finance, means to offset risk – often risks that cannot be insured against or budgeted for.

The most common risks where hedging can be an effective tool are:

• Interest rates moving – It costs more to borrow, or savings bring in a lower rate of return
• Adverse currency movements – exports are worth less or imports cost more
• Rising raw materials costs – a poor crop or a natural/man-made disaster reduces the quantity on the market, or rising demand from other users pushes up the price

How does hedging work?

In financial markets, much hedging is done using derivatives. Be aware that hedging has its critics – particularly the use of financial derivatives as a hedging tool. Some see derivative products as a threat to market stability.

Much of this mistrust stems from the financial crisis of 2008, when a sharp downturn in the US housing market led to a collapse in derivative products linked to US mortgages.

Here, we'll ignore these criticisms and focus on the types of derivative used as tools to hedge against the three risks identified above.

Hedging against interest rate risk

To keep things simple, let’s imagine that a company called DeltaCorp must, in a year, repay a loan of £1m plus a fixed rate of interest of 1.7%.

Now let's say Sigma Group has a similar sized loan and is paying a floating rate of interest, based on six-month LIBOR at 0.5% plus 1%.

Sigma believes that over the next year interest rates will rise, and would like to limit its exposure to this risk.

Delta believes the interest rate environment is benign and it is willing to take a risk that by entering into an interest rate swap with Sigma, the overall annual rate it pays will be lower than the 1.7% it is already liable for.

Swap terms

Delta must still pay its initial lender the 1.7% fixed rate interest on its loan (£17,000), and Sigma must still pay the current floating rate of 0.5% + 1% (£15,000) to its original lender.

But, under the terms of the swap, Delta effectively owes Sigma £15,000, while Sigma owes Delta £17,000. This is partially offset, and so Sigma pays Delta the difference of £2,000.

Now let’s say Sigma’s prediction was right and rates did go up over the year, and the floating rate averaged 0.9% + 1%.

Both parties paid their interest obligations to their initial lenders, but under the terms of the swap agreement, Delta now owes Sigma the new floating rate amount of £19,000, while Sigma still owes Delta £17,000 – a net £2,000 to Sigma.

Sigma successfully hedged its exposure to the rising rate. It still had to pay that higher rate of 0.9% + 1% = £19,000, but received £2,000 under the terms of the swap from Delta. A total interest payment of £17,000 – the same as the 1.7% fixed rate.

Interest rate swaps are customised contracts – the specifications agreed between the two counterparties – but can be an effective way of cutting out the risk of falling interest rates.

The danger is that if the floating rate you pay to your counterparty rises significantly above the flat rate being paid to you, you're on the wrong end of the deal and lose out.

Hedging against currency risk

When companies operate abroad and then repatriate foreign earnings back into their domestic currency, they do so at the risk of currency movements that could adversely affect their profits.

When companies operate abroad they risk currency movements when putting foreign earnings back into their domestic currency.

Here, the corporation can choose between two similar products: futures, which are among the most common derivatives, or forwards, which, like interest rate swaps, are bespoke agreements.

For this exercise, we'll focus on the more common futures market. It is more transparent and accessed on several international exchanges, including Chicago Mercantile Exchange (CME) and Euronext.Liffe.

Exchange rate volatility

Let's say that DeltaCorp, which sells cast aluminium products to a customer in France, is concerned over the volatility of the sterling/euro (£/€) exchange rate.

It expects payment from its fourth-quarter deliveries on 31 December, but is worried the pound will appreciate substantially between agreeing the sale price in September and payment in December.

DeltaCorp sold £100,000 worth of products in September, when £1 bought €1.15, which priced the sale at €115,000. If the pound appreciates to €1.25 by December, the French customer still pays the €115,000 agreed price but DeltaCorp only gets £92,000 for its goods, not the £100,000 it needed.

DeltaCorp can’t afford to lose £8,000 because of currency changes. So it seeks to ensure it doesn’t lose out on any potential currency moves by buying £100,000 of euro futures at a strike price of €1.15.

This means that whatever the exchange rate at the time the invoice is settled, DeltaCorp will get the money it expected when it made the sale.

Hedging against rising materials costs

This is similar in principle to currency hedging, in that corporations are looking to lock in materials purchasing at a particular price, rather than run the gauntlet of buying at spot prices during a period of rising prices.

So, for example, to continue making a profit on its manufacturing, DeltaCorp must buy its aluminium at no higher than £1,500 a tonne.

The futures market indicates it could buy at £1,450 a tonne five months from now, so DeltaCorp enters a futures contract to pay £1,450 for five tonnes in five months.

A fire in a supply factory causes a shortage of aluminium and the price rises to £1,600 per tonne. But DeltaCorp has a contract confirming it only has to pay £1,450, so its product pricing is not at risk.

Corporations are looking to lock in materals purchasing at a particular price, rather than buying at spot prices during a period of rising prices.

Related costs

Hedging can be a useful strategy in protecting revenue streams, and derivatives can be the ideal tool for this strategy.

But any hedger, speculator or investor who seeks to use the derivatives markets should also be aware that there are other costs involved, including commission, transaction charges and contract termination fees.

Remember also that when a risky trade goes wrong it can go spectacularly wrong. JP Morgan, trying to protect its European debt investments, went wrong to the tune of $2bn in the credit default swaps market in 2012.

But with skilful risk management, companies can take advantage of the tools available to hedge currency, interest rate and commodity risk. It can make them leaner, more agile and quicker to react to competition – the airline industry has hedged fuel prices for years.