Hedging instruments part 1

There are four main ways in which price risk can be managed, in this step we are looking at:

• fixed price contracts
• fixing derivatives.

Fixing and option instruments are typically called derivatives.

Fixed price contracts

The simplest way to manage a price risk is to enter into a ‘fixed price’ contract with a supplier or buyer. Fixed price contracts provide certainty on:

• the cost of services or goods being purchased
• the price at which services and goods are sold.

Example 1: certainty vs. opportunity cost

ABC Plc agrees to pay GBP10,000 for a delivery of corn for a delivery in two months’ time. This is on the basis of requiring 200 bushels of corn each priced at GBP50.

Scenario one: In two months’ time, the market price of corn is GBP40 per bushel. Under this scenario ABC Plc will still pay GBP50 per bushel of corn, totalling GBP10,000 for 200 bushels. If ABC Plc had not entered into a fixed price contract the cost would have only been GBP8,000. Therefore, you had an opportunity cost of GBP2,000.

Scenario two: In two months’ time, the market price of corn is GBP60 per bushel. Under this scenario ABC will still pay GBP50 per bushel of corn, totalling GBP10,000 for 200 bushels. If ABC Plc had not entered into a fixed price contract the cost would have been GBP12,000. Therefore, by entering into a fixed price contract ABC Plc saved GBP2,000.

Entering into a fixed price contract ensures price certainty, which for most treasurers is the primary aim of hedging. Hence, the loss shown in scenario one does not reflect badly on the decision to hedge. The objective was to fix the cost in advance: this was achieved.

Entering into a fixed price contract ensures price certainty, which for most treasurers is the primary aim of hedging.

Example 2: fixed price contract with supplier

Farmers Foods Inc., in the USA, uses soya oil. The company contracts with a supplier to purchase 500,000 litres of soya oil every week for the next year at a fixed price of USD0.15 per litre. The company has now secured the supply of its expected requirements for soya oil for the coming year, and it knows the price which it is committed to pay for the soya oil. The risk of changes in the USD price of soya oil has been transferred to the supplier.

Fixing derivatives

A fixing derivative is one which hedges an exposure to a variable market rate or market price (for example, foreign exchange rates, commodity prices or interest rates), by fixing the price, and delivery date.

Where fixed price contracts are separate from the underlying commercial contract, they are examples of instruments called ‘derivatives’, so called because they derive their value from a specified market price, rate or index.

The main type of fixing instruments include are:

• forward contracts to hedge foreign exchange risk
• futures to hedge foreign exchange, interest rate and commodity risk
• swaps, to hedge interest rate risk and foreign exchange risk.

Example 3: fixing derivative

DEF plc is an EU-based supplier of packaging whose accounts are reported in EUR. It has agreed a sale to a US based customer and expects to receive USD250,000 in one month.

Given uncertainty over the EUR/USD spot exchange rate in one month and the tight margins DEF will make on the sale, it has decided to hedge the foreign exchange risk. DEF has therefore entered into a forward contract (a derivative) with its bank to sell USD250,000 to the bank at a rate of EUR/USD1.25000.

This ensures that whatever the market EUR/USD spot rate will be in one month, DEF will receive EUR200,000 from the bank in exchange for delivering the USD250,000 sales proceeds.