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How Companies Use Derivatives To Hedge Risk
How Companies Use Derivatives To Hedge Risk
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BY MARY HALL
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
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:
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. 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; the counter-party will take the opposite
position).
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). We can illustrate these variable rate payments with a
down-bar chart:
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. Note the annual report implies JCI has a perfect hedge: The variable-
rate coupons JCI received exactly compensate for the company's variable-rate
obligations.
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.