A derivative is a financial instrument whose value is reliant upon or derived from an underlying asset. This underlying asset may be a stock, commodity, currency, bond, or market index. Although derivatives can be used for speculation, the main corporate use of derivatives is to hedge, which means to protect an asset, a balance sheet, or cash flow from an unwanted change in price.
The Four Common Derivative Contracts
- Futures: Standardised contracts which are traded on an exchange and which commit both parties to buy or sell an asset at a future date at a price agreed at the time of the contract.
- Forwards: Like futures, except that these are tailor-made over-the-counter (OTC) agreements between two parties and are not traded on a centralized exchange.
- Options: Contracts in which the owner has the right, but not the obligation, to purchase (call option) or sell (put option) the underlying asset at a fixed price, called the strike price, on or before a certain date.
- Swaps: Tailored OTC agreement in which two parties commit to a series of cash flows in exchange. The most widely used are interest rate swaps and currency swaps.
Primary Sources of Corporate Financial Risk
Risk management involves identifying potential financial exposures and putting in place strategies to mitigate the risk. The market risks that a corporation may encounter are as follows:
- Foreign Exchange (FX) / Currency Risk: Risk associated with adverse movement of foreign exchange rates against a company that trades or holds assets/liabilities in foreign currencies.
- Interest Rate Risk: The risk that a company faces when interest rates change in the economy, especially if it has floating interest rates.
- Commodity Price Risk: Risk associated with manufacturers or producers who rely on commodity prices, such as oil, metals, wheat, etc., and which can negatively impact profit margins if commodity prices rise.
- Credit Risk: The risk that a counterparty or borrower fails to fulfill his or her financial obligation.
- Volatility / Price Risk: The risk of sudden increases or decreases in the price of an asset or market sentiment.
Core Approaches to Hedging
Hedging is like having an insurance policy. It mitigates the downside risk of negative price action, but normally at the cost of paying a premium or giving up some upside potential.
- Micro vs. Macro Hedging:
Micro Hedging: Aims to hedge the risk of a specific transaction (e.g., the currency risk of a specific machine purchase from Germany).
Macro Hedging: Provides protection to the company’s overall portfolio-wide exposure across a number of business units.
- Dynamic Hedging: Companies do not simply set a fixed hedge but actively manage the derivative position as market conditions change, benefiting from favourable price moves and limiting losses.
- Natural Hedging: Use of the economics of the business itself to offset the risk without the need for financial contracts.
Example: ACME Corp sells widgets in Europe (in Euros) and manufactures widgets in Germany (in Euros). When the Euro weakens, their manufacturing costs decrease by the same amount as their sales revenue (in USD). In this way, the risk is naturally hedged through dual exposure.
Hedging Strategies by Risk Category
1. Hedging Foreign Exchange (FX) Risk
Companies involved in international trade utilize FX derivatives to gain cost certainty.
- FX Forwards: Lock a specific exchange rate for a future date, giving absolute certainty for import/export costs.
- Currency Options: Provide flexibility. A firm may purchase an option that specifies a “worst-case scenario price” ceiling, but, if the market price is lower, the firm may allow the option to expire and trade at the lower market price.
- Currency Swaps: Multinational corporations with revenues in one currency and expenses in another currency perform a currency swap to help match the cash flow of revenues and expenses.
2. Hedging Interest Rate Risk
A company with floating rate debt is really sensitive to central bank rate increases, such as SOFR or LIBOR.
- Interest Rate Swaps: A corporation trades a variable (floating) rate interest payment with a counterparty for a fixed rate interest payment. This helps keep debt servicing costs on track.
- Interest Rate Caps: When the market rate exceeds the cap rate, the counterparty pays the company the difference. If rates fall, the company benefits from the lower market rate.
3. Hedging Commodity Risk
Companies that rely on raw materials employ derivatives to prevent raw material supply chain cost hikes.
- Commodity Futures: A wheat grower who is concerned about falling wheat prices can sell wheat futures today for a guaranteed selling price when harvest arrives. On the other hand, an airline may purchase oil futures to secure oil prices.
- Commodity Calls: Allow a company to purchase a commodity at a specified price, placing a cap on the raw material’s price at that specified amount, but also giving the company the option to purchase at lower spot rates if the commodity falls below the specified price.
4. Hedging Credit Risk
- Credit Default Swaps (CDS): Financial institutions use CDS to pass the risk of borrower default. The buyer pays a premium to the seller, and the seller agrees to pay the buyer back in case of a default on the underlying debt.
Understanding Options and “The Greeks”
The pricing of options is complicated and depends on a number of market factors. Risk managers use “The Greeks” to measure an option’s sensitivity to these variables:
| Delta (\Delta) | Sensitivity to the underlying asset’s price. | A delta value of 0.5 indicates that the option price changes by ₹0.50 when the underlying asset price changes by ₹1. |
| Gamma (\Gamma) | Rate of change of Delta. | Measures the stability of Delta; how quickly Delta changes as the asset price changes. |
| Theta (\Theta) | Sensitivity to time decay. | Measures the amount of value lost in the option per day as it nears expiration. |
| Vega (\nu) | Sensitivity to market volatility. | The higher the volatility, the higher the value of the options (higher likelihood of ending in-the-money). |
| Rho (\rho) | Sensitivity to interest rates. | As interest rates rise, Call values tend to go up while Put values go down. |
Speculation and Arbitrage
While hedging minimizes risk, derivatives are also used for risk-taking:
- Speculation: Buying and selling with the aim of benefiting from expected price fluctuations (e.g., buying Calls on a stock you think will go up). It uses leverage to manage a big trade with a small amount of capital, which boosts both profits and risks.
- Arbitrage: Buying and selling related instruments simultaneously to take advantage of market inefficiencies and make risk-free profits.
- Cash-and-Carry Arbitrage: When an asset is purchased in the spot market and a related futures contract is sold to profit from mispricing.
- Merger Arbitrage (Risk Arbitrage): Taking advantage of the difference between the target company’s stock price and the acquisition price.
- Covered Interest Arbitrage: Arbitrage based on the difference in interest rates between two countries that utilizes forward contracts to avoid currency risk.