This is the first in a series of three articles that are intended as an introduction to hedging and the use of derivatives. In this first article, we provide an overview and simple illustration of the reasons why companies adopt hedging strategies. In the next part of the series, we will overview the basic risks that are hedged and the most common types of derivatives used as hedging instruments.

A Derivatives and Hedging Primer - Part One

Why Do Companies Hedge?

Companies enter into hedging transactions for a variety of reasons. An important reason to hedge exposures is to eliminate variability and volatility in financial performance, and/or to eliminate variability in cash flows over time. Consistent and predictable financial performance is important to the investment community, as analysts and investors tend to reward companies with stable, upward trends in earnings. Companies like to avoid surprising the investment community; volatility in earnings implies risk. Earnings volatility may depress stock prices and/or increase borrowing costs, which management clearly wants to avoid. Effective hedging programs also allow management to more accurately predict financial performance and manage the investment community's expectations. The ability to accurately forecast revenues and associated expenses allows managers to budget effectively and, to the extent that the budgetary process provides inputs to management's estimates of overall performance, financial performance will be more predictable. As will be illustrated in part three of this series, certain hedges attempt to provide symmetrical returns (where the hedge is designed so that any gains or losses related to the hedged item are offset by gains or losses on the derivative) while other programs seek to provide asymmetrical returns (where the hedge eliminates a downside exposure while allowing the company to experience favorable market changes related to the hedged item). Symmetrical hedge strategies are designed to "lock in" a company's returns while asymmetrical hedge strategies can be analogized to insurance, where the hedge acts as protection against losses.

Does a Company Have to Use Derivatives to Hedge its Exposures?

Companies often modify their exposures to a variety of risks without using derivatives by changing their capital structures or entering into non-derivative transactions; transactions of this type are typically called "natural hedges". For example, a foreign subsidiary of a U.S. based company may opt to borrow in the foreign currency, thereby matching cash inflows (foreign currency denominated revenues) with cash outflows (foreign currency denominated debt service). If the foreign subsidiary borrowed in U.S. dollars rather than the foreign currency, its cash flows would be sensitive to changes in the foreign currency exchange rate. If the dollar strengthened against the foreign currency, additional amounts of foreign currency would be required to satisfy the subsidiary's U.S. dollar denominated obligations.(See Exhibit 1).

There will be situations where management would like to hedge naturally but is unable to do so for a variety of reasons. Often, hedged exposures will change rapidly and management may have to adjust its assets or liabilities frequently to obtain the desired offsets. Additionally, there can be delays related to establishing these on-balance-sheet positions and the company may not be able to enter into the transactions timely enough to establish an effective "natural" hedge.

When a company cannot efficiently hedge its positions naturally, by modifying its cash flows or balance sheet position, management will often use derivatives to accomplish their objectives. Derivatives are often used to fine-tune risk exposures, because they are cost efficient to execute and can be tailored to achieve a desired result. Suppose the financial institution that issued certificates of deposit held floating rate assets (e.g., credit card loans indexed to the prime rate) instead of U.S. Treasury notes and was therefore exposed to the risk of falling interest rates if it left this exposure unhedged. Management could sell its floating rate assets and purchase one year assets to hedge its fixed rate obligation but might find this uneconomical. As an alternative, the company could enter into an interest rate swap to accomplish a similar result. In this situation, the company wants to receive fixed rate earnings to meet its interest payment obligations to the holders of the certificates of deposit, so it enters into a pay floating rate and receive fixed rate swap. The fixed rate receipts related to the swap will offset the fixed rate outflows related to the certificate of deposit and the company will have hedged this exposure. If the fixed rate received on the swap is in excess of the rate paid to the certificate of deposit holders, the company will have locked in a "spread" or margin.(See Exhibit 3).

Does a Company Always Want to Hedge its Exposures?

Management doesn't have to hedge its exposures; it can decide to retain a component of the natural exposure that is created by its operations. For example, the financial institution that naturally had one year liabilities and shorter term assets might want to retain its exposure to the variability of interest rates if management thought that rates were rising. If rates do rise, variable rate assets held by the company will generate additional returns while the rates paid to the holders of the certificates of deposit will not change. By opting not to hedge its exposure, management would be "taking a view" on the direction of interest rates.

Alternatively, management can also introduce an exposure by using a derivative. If the company had a naturally hedged position (e.g. a balance sheet with both fixed rate investments and fixed rate debt), management could enter into a pay fixed interest rate swap to create the same exposure as if it had floating rate assets. Special accounting is permitted for derivatives that qualify under certain hedging criteria.

Derivatives with no hedging purpose are recorded on the company's financial statements at fair value with changes in fair value reflected in current period earnings. One example is a company with no foreign currency exposures which takes a view that a given currency will lose value against the U.S. dollar and enters into a forward transaction to sell a foreign currency for U.S. dollars based on the current contract rate.

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