Understanding Derivatives Chapter 4 Hedging PDF
Understanding Derivatives Chapter 4 Hedging PDF
Understanding Derivatives Chapter 4 Hedging PDF
04 Hedging
Richard Heckinger, vice president and senior policy advisor, Ivana Ruffini,
senior policy specialist, financial markets, Federal Reserve Bank of Chicago.
The vast majority of the world’s top 500 companies (94%) actively
hedge their various risk exposures (ISDA, 2009). Still, it is impor-
tant to keep in mind that hedging is done not only by sophisticated,
publicly traded, global conglomerates, but also by counties, munic-
ipalities, and school districts; and occasionally, such entities incur
large losses as a result. Examples include the near bankruptcy of
Jefferson County, Alabama, and Erie City School District, Pennsylvania
(Braun and Selway, 2008). Reports of these losses have prompted
some to question whether all this hedging activity is necessary, or
even desirable. While opinions on this subject differ, it is clear that
hedging is a powerful risk management technique and that under
certain circumstances, it is beneficial.
In this chapter, we demystify the concept of hedging and
illustrate the risk–reward tradeoff inherent in hedges through examples.
We explain how hedges work; the risks associated with hedging;
and the relevant rules and regulations.
Predictability and growth of future cash flows are important for every-
one—corporations, municipalities, non-profit entities, and individuals.
Steady, increasing cash flows positively impact company valuations
and access to capital. Conversely, poor cash flow forecasting and man-
agement can cause a liquidity problem for a firm and can even lead to
its insolvency. Thus, control of earnings volatility is a key management
objective for many organizations. Forecasting swings in revenues and
costs depends on a myriad of factors, so management may be willing
to cap potential expected returns in order to limit potential losses. One
way to do this is through the implementation of a hedging program.
Some empirical studies show that while hedging is indeed
widespread, the economic impact is minor (Guay and Kothari, 2003;
Carter, Rogers, and Simkins, 2002; Smithson and Simkins, 2005).
That is to be expected. By design, effective hedges are meant to
stabilize expected cash flows. To understand the impact hedging
has on the predictability of future cash flows, consider the following
foreign exchange (FX) hedge scenario.
Example: A European company expects a payment from their
U.S. client in June 2015 in the amount of $5 million. Upon the receipt
of the payment, the company will need to convert the receivable
denominated in U.S. dollars to euros. To eliminate the risk of an
unfavorable exchange rate move, the company chooses to enter into
a hedge using EUR/USD futures that expire in June 2015.
The current price of the June 2015 contract is 1.2195, which
means that the current value of the receivable is EUR 4,100,041, which
is $5,000,000 divided by 1.2195. The goal of the hedge is for the com-
pany to receive EUR 4,100,041 in June 2015, regardless of where the
exchange rates end up. The company picks a futures contract with the
size of EUR 100,000. In this case, the value of each contract in U.S.
dollars is $121,950. Dividing the $5 million receivable by the contract
dollar value gives us 41.00041, thus 41 contracts are needed to hedge
the exposure. (See box 1.)
The example shows that through hedging the company was
able to mitigate the impact of currency exchange rate fluctuations
and eliminate volatility. It cost less than 3 euro to prevent a poten-
tial loss of 253,887.15 euro on one receivable. At the same time, the
hedge also prevented the company from materializing a potential
profit due to a favorable change in FX rates, which exemplifies the
risk–reward trade off inherent in hedging activity.
Possible profit and loss (PnL) outcomes on the day the receivable is paid.
1) Euro strengthens against the U.S. dollar => 1 EUR = 1.3000 USD
Receivable value (RV) = USD 5,000,000/1.3000 = EUR 3,846,153.85
3,846,153.85 – 4,100,041 = –253,887.15
Loss on RV is EUR 253,887.15
Hedge value (HV) = 41*100,000*(1.3 – 1.2195) = USD 330,050 or EUR 253,884.61
Profit on HV is EUR 253,884.61
RV+HV = –253,887.15 EUR + EUR 253,884.61 = –2.54 EUR
The net of the receivable and the hedge position is a total loss of EUR 2.54.
2) The exchange rate remains unchanged => 1 EUR = 1.2195 USD
Receivable value (RV) = USD 5,000,000/1.2195 = EUR 4,100,041
4,100,041 – 4,100,041 = 0
There is no change in RV.
Hedge value (HV) = 41*100,000*(1.2195 – 1.2195) = 0
There is no profit or loss on the value of the hedge.
RV + HV = 0 + 0 = 0
There is no change in PnL.
3) Euro weakens against the US dollar => 1 EUR = 1.2000 USD
Receivable value (RV) = USD 5,000,000/1.2000 = EUR 4,166,666.67
4,166,666.67 – 4,100,041 = 66,625.67
Profit on RV is EUR 66,625.67
Hedge value (HV) = 41*100,000*(1.2 – 1.2195) = –79,990 USD or –66,625 EUR
Profit on HV is EUR 253,884.61
RV + HV = EUR 66,625.67 + (–66,625 EUR) = EUR 0.67
The net of the receivable and the hedge position is a total profit of EUR 0.67.
Derivative
type (%)
# of % using Interest
Industry comp. derivatives rates FX Commodity Credit Equity
Financial
123 98 94 96 63 76 80
Basic
materials 86 97 70 85 79 -- 6
Technology 65 95 86 92 15 6 15
Healthcare 25 92 80 72 8 4 20
Industrial
goods 49 92 86 86 37 2 20
Utilities 24 92 92 88 83 -- 8
Consumer
goods 88 91 81 84 39 1 9
Services 40 88 75 85 35 3 13
Total 500 94 83 88 49 20 29
Source: ISDA Survey Results: Derivatives Usage by the World’s Largest Companies,
April 2009, available at http://www.isda.org/press/press042309der.pdf.
Basis Risk
A hedge does not have to be perfect to reduce risk exposure, and
the risk that emerges as a result of imperfect hedges is basis risk.
Specifically, the basis risk is the difference in the way the prices
change between the derivative contract and the asset or liability
being hedged. Generally, a lower historical price correlation im-
plies a larger basis risk (and vice versa).
Basis risk is not a constant; it can fluctuate over the life of
the hedge. It widens (increases) due to mismatches between the un-
derlying exposure and the derivative contract used to hedge such an
exposure. Thus, differences in dates (expiration, maturity, purchase),
delivery instructions (location, transportation and storage costs),
and changes in yield curves—all result in basis risk exposure.
The difference between the timing of the hedger’s commer-
cial transactions and the standardized delivery dates of exchange-
traded derivatives creates the basis risk exposure. The price of
forward, futures, or options contracts will converge to the cash
price at the time the derivatives expire or result in delivery. Most
contracts are closed out by an offsetting transaction before actual
Quantity Risk
The risk of over or under hedging related to the number of contracts
used in a hedge is referred to as quantity risk. Exchange-traded
derivatives cover a standard size or quantity of the underlying instru-
ment, and the use of such contracts may expose a hedger to quanti-
ty risk. As mentioned in previous chapters, OTC derivatives can be
custom fit to the risk being hedged in order to reduce basis risk and
According to its 1999 annual report, Southwest Airlines has been hedging its exposure to jet fuel
price fluctuations since the late 1990s.1 Several case studies have been written touting South-
west’s successful hedging program. For many years, crude prices continually climbed. During
that time, Southwest’s hedges against rising prices worked very well. In the summer of 2008, the
price of crude oil recorded new highs and Southwest’s second-quarter gain on its hedges
amounted to $1.2 billion net of taxes.2 However, eventually oil prices began to drop and South-
west’s hedging activities backfired in Q3:2008. Consequently, Southwest recorded a $1.6 billion
loss on its hedge portfolio and had a losing quarter for the first time in 17 years (Jetter, 2008).
Southwest Airlines, Form 10-Q, July 28, 2008, page 10, available at http://southwest.investorroom.com/sec-filings?s=127&year=2008&cat=.
2
Regulatory Impact
Summary
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municipal swaps,” Bloomberg, September 4, available at http://www.bloomberg.com/
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Carter, David A., Daniel A. Rogers, and Betty J. Simkins, 2002, “Does fuel hedging make
economic sense? The case of the US airline industry,” paper, September 16, available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=325402.
Coleman, Les, 2009, Risk Strategies: Dialling Up Optimum Firm Risk, Farnham, Surrey,
UK: Gower Publishing.
Financial Accounting Foundation, Financial Accounting Standards Board, 1998, Statement
of Financial Accounting Standards No. 133: Accounting for Derivative Instruments and
Hedging Activities, Norwalk, CT, June, available at http://www.fasb.org/cs/BlobServer?b
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Fisher, Bryan, and Ankush Kumar, 2010, “The right way to hedge,” Insights & Publications,
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Graff, Jennifer, Ted Schroeder, Rodney Jones, and Kevin Dhuyvetter, 1997, “Cross hedging
agricultural commodities,” paper, Kansas State University, Agricultural Experiment
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Guay, Wayne, and S. P. Kothari, 2003, “How much do firms hedge with derivatives?,”
Journal of Financial Economics, Vol. 70, No. 3, December, pp. 423–461.
International Accounting Standards Board, 2014, Financial Instruments (replacement
of IAS 39), “IFRS 9 financial instruments (replacement of IAS 39),” webpage, July,
available at http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-
A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Pages/Financial-Instruments-
Replacement-of-IAS-39.aspx.
International Swaps and Derivatives Association, 2014, “Dispelling myths: End-user
activity in OTC derivatives,” research study, New York, August 11, available at
http://www2.isda.org/functional-areas/research/studies/.
__________, 2009, “Over 94% of the world’s largest companies use derivatives to help
manage their risks, according to ISDA survey,” news release, Beijing, April 23, available
at http://www.isda.org/press/press042309der.pdf.
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