Investors may associate derivatives speculation with large economic scandals such as those experienced by China Aviation and Citigroup in 2004, Amaranth Advisors in 2006, and Société Générale in 2008. In addition, investment gurus such as Warren Buffet have famously decried their use, equating them to a “time bomb” (2003 Berkshire Hathaway Annual Report).
Yet, as with any tool, derivative instruments are neither good nor bad in themselves, and their use for corporate risk management has grown dramatically during the past decades. Before eliminating this potentially beneficent tool from your arsenal, you should understand how hedging with derivative works and—if appropriately used—how these instruments can effectively protect your organization from financial risk exposures such as currency, commodity, and interest rate risk.
Hedging with derivatives could become a value-enhancing activity for your corporation because taxes, bankruptcy, and underinvestment costs make volatility expensive. By reducing volatility in cash flows and profits, hedging enables your organization to successfully plan and implement future investments, as well as minimize payable tax. This strategic planning can increase your firm’s financial value, and an optimal hedging strategy can protect your employees, customers, and suppliers by decreasing the probability of your company experiencing financial distress.
If you are serious about adding this tool to your financial strategy, you and the decision makers in your company must address these questions to make your plan a success:
- What are our motives for managing risk exposures?
- What hedging instruments are available to us?
- What positions in these instruments will reduce our financial risks?
- What are we risking if we use derivatives?
- What is the most effective way for us to organize the risk management activities within our organization?
- What level of expertise in our different divisions will be required for these activities?
- What costs will we incur to use derivatives?
Is your company prepared to employ hedging with derivatives to your benefit? The Accenture Academy course Fundamentals of Hedging explores the motives, the tools, and the strategies for smart financial hedging to protect your organization from financial risks and enhance your company’s value.