Beginner's guide to hedging

The practice of risk management aims to reduce a company’s exposure to market risks outside of its control. Often companies try to accomplish this through operational means, issuing fixed-rate debt, billing customers in USD, or using fixed-price supply contracts. Unfortunately, not all risks can be managed operationally, so companies use financial contracts, called derivatives, to reduce risk when operational strategies are not enough.

Basics of hedging

• Sources of risk
• How to approach risk
• Why do companies hedge?
• Common derivative products
  • Products to lock in prices
  • Products with optionality
  • Combination products
• The risk management lifecycle

Sources of risk

Three primary sources of market risk for corporations are interest rate risk, foreign exchange risk, and commodity risk.

Interest rate markets

The most common way that interest rate risk manifests itself for corporations is through floating rate debt, which bears interest on variable rates such as LIBOR or SOFR. As these rates rise, the periodic interest payments on a floating rate borrowing will increase, leaving a corporation with exposure to interest rate risk. Short-term interest rates are driven by actions and expectations of the central bank and its monetary policy. The U.S. Central Bank, the Federal Reserve, sets a short-term borrowing rate target known as the federal funds target rate, which influences movements in prevailing short-term interest rates such as LIBOR and SOFR. Longer-term rates are primarily driven by future inflation expectations and economic growth expectations. Generally, as inflation expectations for the future rise, long-term interest rates rise as a result. The supply and demand of government securities, along with risk sentiment in capital markets, can also drive movements in interest rates.

Foreign exchange markets

Foreign exchange rate risk often arises for a corporation when it is involved in operations across multiple countries as changes in the exchange rate between two nations will have a financial impact on the company. For example, if the company has EUR receivables sitting on its subsidiary’s balance sheet that will revalue in its home currency of USD, or if the company needs to convert JPY revenues earned back into USD, it is exposed to changes in exchange rates. Main drivers in the movement of exchange rates include economic growth expectations for each respective nation/zone, interest rates in both areas, political landscapes, investor risk sentiment, and the supply and demand for different currencies.

Commodity markets

Many corporations are exposed to commodity prices which encompass everything from energy (including oil and gas), to metals (including aluminum and gold), to agricultural products (including corn and soybean oil). For instance, if a company ships its products from manufacturing plants into stores via trucks that consume gasoline, the company is exposed to the price of gasoline rising. Commodity prices are driven by impacts to and future expectations for the supply and demand for the given commodity. Economic outlook, stockpiles, and weather impacts all often contribute to movement in prices. Geopolitical factors can also play a role in commodity prices, especially when certain countries hold large reserves of a commodity.

How to approach risk

Finding the right risk management solution requires a company to be aware of three important areas:

1. Market awareness

• What markets does the company have exposure to?
  
• How volatile are the markets?

2. Business profile awareness

• What is the business’s tolerance for risk?
  
• How can risk be mitigated through natural hedges?
  
• What are peers doing to manage risk?

3. Hedging solution awareness

• What operational measures can be taken to reduce risk?
  
• What derivative products exist to mitigate risk?

Note that the ideal approach to hedging can vary significantly depending on the asset class and business profile.

Why do companies hedge?

Ideally, if a company can immediately adjust its underlying business to adapt to market changes, it will not need to hedge. However, few companies can adapt in real-time as it takes time and money to adjust business operations. Therefore, financial hedges are needed to allow a company to manage unexpected risks while providing time to explore and implement appropriate business strategies. Most corporates find that the benefits are worth the costs. Here is a simple breakdown of why to hedge:

Common derivative products

A derivative is a financial contract whose value is derived from the value of an underlying asset. Derivatives are used as tools to adjust the risk profile of an underlying exposure in order to decrease a company’s financial risk. When used appropriately as a hedge, derivatives act as a natural offset to the underlying exposure. So, if the underlying exposure is adversely impacted by rate/price movement, the hedge in contrast will be an asset; if the underlying exposure is positively impacted, the hedge will be a liability.

Derivative products are completely customizable, but generally fall into three categories: locking in a fixed price, setting a floor or ceiling on a price, or a combination of setting both a floor and ceiling on a price.

Products to lock in prices

These products allow a company to achieve a fixed price in the future. Regardless of how prices move the company knows what they will pay.

Interest rate swaps synthetically convert floating rate debt to fixed rate debt. The borrower pays a fixed swap rate to the swap provider in exchange for receiving a floating rate (i.e. 1-month Term SOFR). The floating rate received from the swap provider cancels out the floating rate interest payment due on the loan. At the end of the day, the borrower is left paying interest based on the fixed swap rate — a rate that is locked in with a hedge provider based on current expectations of interest rates over the life of the swap.

FX forward contracts allow two parties to exchange a specified amount of one currency for a specified amount of a second currency on a pre-defined future date, locking in a fixed exchange rate. The forward allows a company to lock in a known conversion rate on the given maturity date in order to remove all risk to movements in exchange rates.

Commodity futures allow a company to lock in a fixed price for a commodity over a specified period of time in the future. Swaps are traded over-the-counter while futures are traded on an exchange. Futures will be marked-to-market on a daily basis, and cash collateral posting will be required over the lifetime of the contract.

Products with optionality

Options give you the right but not the obligation to do something. This characteristic makes options different from most other financial contracts — forwards, swaps, futures — in which fulfilling the contract is not optional. This optionality comes at an upfront cost, the option premium. While the premium requires a cash outlay, purchased options are not credit intensive, making them advantageous for corporations that do not have sufficient credit capacity with bank counterparties. Below are vanilla options across the three risk classes:

• Interest rate caps set a specific ceiling on the interest rate, called the cap strike. If rates rise above the cap strike, the counterparty pays the company the difference in the underlying rate and the strike rate. However, if rates fall below the cap strike, the company pays the prevailing lower rate.

• FX option contracts provide the right, but not the obligation, to exchange one currency for another at a set rate. This product sets a limit on the worst case exchange rate but allows a company to take advantage of more favorable exchange rates if the market moves in the company’s favor,

• Commodity calls give the company the right but not the obligation to buy a designated commodity at a set price in the future. As shown in the payoff profile below, a call option will set a ceiling, or a worst-case scenario, on the underlying commodity price that the company will pay.

Note: the above products are purchased options (rather than sold). They are commonly referred to as call options (rather than put options). For more information, read our guides on FX options, commodity call options, and/or commodity put options.

Combination products

Combination products are highly customizable. A common combination product is a collar. Collars effectively set a band of outcomes that prices can float within, setting a known worst-case and a known best-case scenario. Generally, these are structured in a way that is cheaper than an option but still provides protection for the company.

Below is a high-level summary of common derivative products from the information above:

The risk management lifecycle

Once companies understand the derivative products available to them, they can consider how to use those products to drive an effective risk management program.

Some of the challenges in managing derivatives programs include:

• Measuring hedging strategy effectiveness, including what metrics to use, and how to retroactively determine if the program managed to achieve a sufficient risk tolerance.
• Accurately forecasting future risks and exposures.
• Understanding your business landscape and evolving the program to keep pace with business changes.
• Determining which risks are static and which risks should be considered on a growth factor basis.
• Understanding how to make the right decisions from both an economic and from a hedge accounting perspective.

Chatham Financial corporate treasury advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.