Hedging Interest Rate Risk

Companies can hedge interest rate risk in various ways. Consider a company expecting to sell a division in one year and receive a cash windfall it wants to "park" in a good risk-free investment. If the company strongly believes interest rates will drop between now and then, it could purchase (or take a long position on) a Treasury futures contract. The company is effectively locking in the future interest rate.

Here is a different example of a perfect interest rate hedge used by Johnson Controls (JCI), as noted in its 2004 annual report:

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.³

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.⁴

Commodity or Product Input Hedge

Companies depending heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases.

Monsanto produces agricultural products, herbicides, and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:

Changes in Commodity Prices: Monsanto uses futures contracts to protect itself against commodity price increases ... these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for soybean and corn inventories. A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn. We also use natural-gas swaps to manage energy input costs. A 10 percent decrease in the price of gas would have a negative effect on the fair value of the swaps of $1 million.⁵

The Bottom Line

We have reviewed three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented. For example, companies can hedge their weather risk to compensate them for the extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign exchange or interest rate movements and unexpected increases in input costs.

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.