Why do non-financial firms use derivatives?
You have seen how financial companies use derivatives. You have also seen how non-financial firms use derivatives to manage risk, concerning the prices they receive for the goods and services they sell, or the prices they pay for inputs. For example, you saw how to use commodity futures and forward contracts.
But can you think of other reasons why non-financial companies use derivatives?
If firms are unable to finance their projects, they may turn to derivatives. Company ownership and remuneration systems also influence how managers use derivatives. And firms use derivatives if their operations are fundamentally uncertain. Let’s look at these three aspects now.
Most finance for investment comes from internal funds (undistributed profits). In addition, firms use external sources of finance, issuing shares, selling bonds, or using loan finance. However, it is not always possible to obtain the quantity of finance the firm needs, or the cost of finance is too high. This can happen due to information asymmetries – the firm’s managers or owners know a project will create value, but the bank manager is harder to convince. We say such firms face financial constraints. One reason firms use derivative instruments is to reduce these financial constraints and to ease the financial distress of the company.
You have probably realised that derivatives can reduce risk but they do not always increase profits. Suppose you are a purchasing manager in an energy company. You believe your job security depends on stability, and on reducing the volatility of the company’s earnings and cash flow. You enter into forward contracts to purchase fuel, to fix the price you pay. But what if energy prices fall below the forward price? The owners of the company might ask why you have not paid the lower energy prices. You appear to value certainty more than profit maximisation. The potential for conflict between the principal (the owners) and the agent (the manager) is known as the principal-agent problem. It explains why some non-financial firms use derivatives even when it contradicts the best interests of the owners.
Remuneration systems and ownership structures are designed to address the principal-agent problem. For example, managers are awarded stock options to align their interests with those of the company. Stock options give the manager the right to purchase the company stock at an agreed price and date. If the share price is above the exercise price on the maturity date, the manager can benefit from exercising their stock options.
Researchers have suggested that managers with large stock option holdings are less likely to hedge and more likely to take risks. By taking on greater risk, managers increase the volatility of future cash flows, and this increases the expected value of their options. You may recall that volatility is part of the Black-Scholes option pricing model. Greater volatility increases option values, because there is more chance the stock price will move sufficiently for the option to be worth exercising.
If you were a manager, do you think owning some of the company’s shares would make you more or less likely to hedge the company’s risk?
You have seen how non-financial firms use hedging to manage uncertainty concerning prices. Firms also use hedging if the outcomes of the firm’s operations are fundamentally uncertain. Consider pharmaceutical and biotechnology firms, which invest substantially in research and development. This involves large sunk costs (costs that cannot be recovered) and uncertainty concerning the outcomes. Hedging of these risks can increase value for the companies.
Can you think of other examples where non-financial companies use derivatives?