How Companies Use Derivatives To Hedge Risk

The war in Ukraine has sent shockwaves through the global economy, with energy prices skyrocketing. This surge in costs threatens businesses of all sizes. While companies can’t control global events, they can employ powerful financial tools to shield themselves from unforeseen risks using derivatives. These versatile instruments allow businesses to lock in prices, avoid currency fluctuations, and hedge against interest rate swings. 

In this blog, we’ll explore how companies can leverage derivatives for hedging to navigate uncertain waters and ensure financial stability. But before diving in, let’s refresh ourselves on some key concepts.

What Are Derivatives

Derivatives are financial contracts that derive their value from an underlying asset, like a commodity (oil, wheat), currency (US dollar, Euro), or even another financial instrument (stocks, bonds). These contracts don’t involve directly buying or selling the underlying asset itself. Instead, they focus on the future value of that asset and allow the parties involved to agree on a price for it at a specific future date. A few examples of derivatives are currency swaps, stock options, oil futures contracts, etc. 

Types of Derivatives

There are several ways to categorise derivatives, but two common classifications focus on their function and structure:

Types of Derivatives By Structure

Exchange-Traded Derivatives: These are standardised contracts traded on a regulated exchange, ensuring transparency and liquidity. Examples include futures and options contracts on commodities, currencies, and indices.

Over-the-Counter (OTC) Derivatives: These are customised contracts negotiated directly between two counterparties, often used for complex financial needs. Examples include interest rate swaps and credit default swaps.

Types of Derivatives By Characteristics

There are four main types of derivatives, each with its own features:

Futures: Agreements to buy or sell an asset at a predetermined price on a specific future date. (e.g.Agreeing today to buy oil at a set price three months from now).

Options: Contracts granting the right, but not the obligation, to buy or sell an asset at a certain price by a certain time. (e.g., Having the option to buy a stock at a set price within the next month).

Swaps: Involve exchanging one set of financial obligations for another between two parties. (e.g., Company A with a fixed-rate loan swapping interest payments with Company B’s variable-rate loan).

Forwards: Similar to futures, private agreements between two parties are often customised to specific needs. (e.g., A jewellery maker agreeing to buy gold from a supplier at a set price in the future).

Disclaimer: Derivatives are complex financial instruments and require careful consideration before use. While they can be a valuable tool, they also carry inherent risks if not used strategically.

What is Hedging?

Hedging is a risk management technique used in finance to protect against potential losses from fluctuations in the price of assets, currencies, or interest rates. It involves taking an opposite position in a derivative contract or another financial instrument to offset potential losses in an existing investment.

Think of it like an insurance policy for your investments. While it won’t guarantee profits, it can help minimise potential losses arising from unexpected market movements.

How can companies use derivatives for hedging?

Companies can leverage derivatives in various ways to hedge against potential risks in their operations. Here are some common applications:

1. Hedging with F&O Contracts

Companies use derivatives for hedging by securing their portfolios with futures or options contracts. This strategy helps protect them from unexpected price swings in the market. For instance, companies might hold multiple shares in their account in cash, and if the prices go up, they can book a profit. However, to protect their investment and secure their portfolio, they buy put options or sell futures against their holdings. These put options or sell futures can be based on an index or a specific company’s stock, providing a safeguard against potential losses.

By using these hedging techniques, companies can stabilise their cash flow and predict costs more accurately, even in volatile market conditions. However, while this approach can limit losses if prices drop, it also caps potential gains if prices rise significantly.

2. Hedging Commodity Price Fluctuations:

Imagine an airline facing volatile jet fuel costs. To shield themselves from price spikes, they can enter into futures contracts. These contracts lock in a fixed price for jet fuel deliveries at a future date. If the actual price surges, the airline benefits from the pre-agreed-upon lower price.

3. Mitigating Currency Fluctuations:

A clothing manufacturer importing materials from a country with a volatile currency could use currency swaps. This derivative allows them to exchange a fixed amount of their home currency for a set amount of foreign currency at a predetermined exchange rate. This ensures they know exactly how much their materials will cost, regardless of future currency fluctuations.

4. Managing Interest Rate Risk:

A company with a large variable-rate loan might be concerned about rising interest rates increasing their borrowing costs. They could utilise interest rate swaps. This derivative allows them essentially to lock in a fixed interest rate for their loan, protecting them from potential future hikes.

Hedging in Action: Examples with Derivatives

Well, nothing is clearly evident without an example. Here is a real-life example of using derivatives to hedge risk:

Airlines Taking Flight with Certainty

Let’s take the example of a major airline like American Airlines (AAL), which faces unpredictable fluctuations in jet fuel prices. In 2022, jet fuel costs reached record highs, impacting airlines globally.

The risk to the company is rising jet fuel prices which can significantly squeeze profit margins and even force airlines to raise ticket prices. According to a 2022 report by the Air Transport Association (IATA), jet fuel is typically the single largest expense for airlines, accounting for around 20-30% of operating costs.

The Hedge

Airlines like American Airlines utilise futures contracts to purchase jet fuel at a predetermined price for a set period in the future. If jet fuel prices skyrocket, as they did in 2022, airlines with hedging strategies benefit from the lower price locked in through the futures contract. This protects their bottom line and allows them to maintain predictable costs for budgeting purposes. A study by Airline Weekly in 2023 found that airlines with effective hedging strategies were able to mitigate fuel cost increases by up to 50% compared to those without hedges.

Conclusion

Derivatives are a double-edged sword. They offer a powerful tool – a financial shield – to help businesses navigate these turbulent waters. companies across industries – airlines, manufacturers, and construction firms – use derivatives for hedging purposes. By locking in future prices, exchange rates, or interest rates, they mitigate risk and gain greater cost certainty. However, without proper understanding and strategic execution, derivatives can also lead to significant losses. By staying informed and using derivatives wisely, companies can guide the ever-changing economic situations with greater confidence and control over their financial future.

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