Actual Use of Derivatives

Ross-Westerfield-Jaffe: VI. Options, Futures, and Corporate Finance, Sixth Corporate Finance Edition

25. Derivatives and Hedging Risk

® The McGraw-Hill Companies, 2002

Chapter 25 Derivatives and Hedging Risk

■ TABLE 25.9 Derivative Usage by Firms Using Derivatives

Exposure Managed with Derivatives

Exposure Not Managed with Derivatives

Foreign exchange Interest rate Commodity Equity

Source: Gordon M. Bodnar, Gregory S. Hayt, and Richard Marston, "1998 Wharton Survey of Financial Risk Management of U.S. Non-Financial Firms," Financial Management (Winter 1998). Survey included 400 firms; 50 percent of the firms reported using derivatives.

The prevailing view is that derivatives can be very helpful in reducing the variability of firm cash flows, which, in turn, reduces the various costs associated with financial distress. Therefore, it is somewhat puzzling that large firms use derivatives more often than small firms—because large firms tend to have less cash flow variability than small firms. Also some surveys report that firms occasionally use derivatives when they want to speculate about future prices and not just to hedge risks.25

However, most of the evidence is consistent with the theory that derivatives are most frequently used by firms where financial distress costs are high and access to the capital markets is constrained.26

1. Firms hedge to reduce risk. This chapter shows a number of hedging strategies.

2. A forward contract is an agreement by two parties to sell an item for cash at a later date. The price is set at the time the agreement is signed. However, cash changes hands on the date of delivery. Forward contracts are generally not traded on organized exchanges.

3. Futures contracts are also agreements for future delivery. They have certain advantages, such as liquidity, that forward contracts do not. An unusual feature of futures contracts is the mark-to-the-market convention. If the price of a futures contract falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money from the clearinghouse. Everything is reversed if the price rises. The mark-to-the-market convention prevents defaults on futures contracts.

4. We divided hedges into two types: short hedges and long hedges. An individual or firm that sells a futures contract to reduce risk is instituting a short hedge. Short hedges are generally appropriate for holders of inventory. An individual or firm that buys a futures contract to

25Walter Dolde, "The Trajectory of Corporate Financial Risk Management," Journal of Applied Corporate Finance (Fall 1993).

26Shawn D. Howton and Steven B. Perfect, "Currency and Interest-Rate Derivatives Use in U.S. Firms," Financial Management (Winter 1998). See also H. Berkman and M. E. Bradbury, "Empirical Evidence on the Corporate Use of Derivatives," Financial Management (Summer 1996).

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