The financial world is one of risk and reward. Thus, financial controllers must employ strategies to minimize risks and maximize their rewards.
Since the 17th century, “hedging” has been used as a word picture of protecting one’s financial investments. Today, hedging strategies have become much more diverse and complex. In this post, we’ll explore the relationship between derivatives and hedging.
Understanding Hedging and Derivatives
Before we begin, it’s important to have a working definition of both “hedging” and “derivatives.”
Hedging
Hedging is a strategy used to minimize risk. It involves taking a position that offsets another in order to balance the risk of one investment with another. Basically, it’s the same principle as an insurance policy. When you take out an insurance policy, you pay monthly premiums to prevent future loss. Even if you never need to use your policy, it’s wiser to accept the calculated loss of your monthly premiums than the major cost of an accident.
Hedging works the same way. Controllers “hedge” by making an investment that reduces the risk of price fluctuations in a financial asset.
Derivatives
A derivative is a financial commodity that derives its value from an underlying asset. Some of the most common derivatives include the following:
- Futures contracts
- Forward contracts
- Swaps
- Option contracts
These derivatives are generally not traded on exchanges, but instead used as part of a larger hedging strategy to manage a financial institution’s risks and rewards.
How Derivatives Are Used in Hedging
There are many ways that derivatives can be used for hedging. The three most common include interest rate risks, foreign exchange risks, and commodity/product input price risk. We’ll examine each below.
Interest Rate Risk
Interest rate risk refers to losses incurred from changes in interest rates. As interest rates rise, the value of bonds decreases. The change in a bond’s value is known as its duration.
Controllers can practice hedging strategies by having diverse bonds with varied durations. Another strategy is to purchase a long-term fixed-income investment. Purchasing a futures contract can be a means of locking in a future interest rate.
Foreign Exchange Risks
A foreign exchange risk results from changes in currency exchange rates. This is particularly concerning to investors who operate in the international market.
Controllers can hedge against this risk through long-dated forward contracts. A forward is a contract between two parties agreeing to buy or sell an asset at a predetermined price. A long-dated forward typically has a settlement date as far as 10 years into the future.
How does this help with hedging? Imagine that your company anticipates that 5 years from now, you will need $2 million to cover the costs. You enter into a forward contract with your financial institution to buy $2 million in 5 years at the cost of $1.50 per dollar.
If the currency should change during this 5-year period, one of the two parties may owe the other the difference. But the purpose of the contract is to ensure that your institution obtains the funds it needs, and it can help mitigate foreign exchange risk.
Commodity or Product Input Price Risk
Some companies may rely on raw materials to operate their business. Agricultural companies, for example, may rely on materials such as fuel, pesticides, and fertilizer. Because these items are needed in massive quantities, seasonal performance rises and falls with the price of these commodities.
Again, futures contracts can be used as a hedging strategy. In our above example, the agricultural company agrees to purchase pesticide in the future at an agreed-upon price. In this case, the futures contract operates very much like an insurance policy. On the one hand, the company may end up paying a higher price than the cost of pesticide one year from now. But on the other hand, this calculated risk may be preferable to paying an exorbitant price if the cost of these commodities should suddenly increase in price.
New Hedging Strategies
The above are some of the most common derivatives used in hedging strategies today. However, new derivatives are being created all the time.
Derivatives have been used in mitigating weather risk, which refers to changes in gains/losses due to the climate. Weather risk typically has the greatest impact on agriculture and certain forms of tourism and travel.
Weather derivatives can be used to lock in exchange rates and the price of certain weather-sensitive commodities, ensuring an agreed-upon value regardless of what happens with Mother Nature.
The Art and Science of Modern Finance
Of course, there is no crystal ball through which controllers can predict future financial changes. That being so, hedging strategies are as much an art as they are a science.
Wise controllers can make the most of company investments and assets through these hedging methods but should also remember that hedging offers little more than a form of damage control.
Still, in today’s insecure world, hedging plays a valuable role in providing security and stability, and can protect a company for years to come.
Learn more in our on-demand webinar: Best Way to Plan for Growth During Market Volatility.
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