How Companies Use Derivatives to Hedge Risk
If you are considering a stock investment and read the company uses derivatives to hedge some risk, should you be concerned or reassured? Warren Buffett's stand is famous: He has attacked all derivatives, saying he and his company "view them as time bombs, both for the parties that deal in them and the economic system ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." On the other hand, the trading volume of derivatives has escalated rapidly, and non-financial companies continue to purchase and trade them in ever-greater numbers.
One of the more common corporate uses of derivatives is for hedging foreign currency risk, or foreign exchange risk, which is the risk a change in currency exchange rates will adversely impact business results.
Let's consider an example of foreign currency risk with ACME Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, ACME Corp sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000 euros worth of widgets.
When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: It can boost export sales of U.S. companies. (Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U.S. exporter when the dollar is depreciating.)
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:
1. We assumed ACME Corp. manufactures its product in the U.S. and therefore incurs its inventory or production costs in dollars. If instead, ACME manufactured its German widgets in Germany, production costs would be incurred in euros. So even if dollar sales increase due to depreciation in the dollar, production costs will go up too. This effect on both sales and costs is called a natural hedge: The economics of the business provide their own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs.
2. We also assumed all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices.
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).
In this example, the futures contract is a separate transaction, but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it's not a free lunch: If the dollar were to weaken instead, the increased export sales are mitigated (partially offset) by losses on the futures contracts.