Derivatives and hedging

2. Hedging activities

Recall from our discussion of foreign currency transactions that a company with international suppliers or buyers can lose money due to changes in currency values between the date of purchase and the date of payment. Because of the nature of derivatives, companies have the option to eliminate or substantially reduce these kinds of risks. Here are some situations where hedging can be an effective risk management tool:

Situation 1 - Friends Company sells merchandise to a British buyer on credit, and the transaction is denominated in British pounds. The company can sign a forward contract to sell British pounds for U.S. dollars at a specific price on the date the receivable is due to avoid the risk that the pound loses value between now and then. If the price goes down, the transaction itself will lose value but the forward contract’s value will go up at the same rate.

Situation 2 - XYZ Corporation needs to buy a large quantity of titanium in two months. To eliminate the risk of paying more for the metal because the price has gone up, the company can sign a forward contract to sell the same quantity of titanium in two months.

Situation 3 - ABC Corporation wants to acquire another company later this year by trading shares of its own stock for all the stock of the other company. To reduce the risk that ABC’s stock value drops before the date of the purchase, ABC can buy a put option on its own stock. If the stock price goes down and the company has to issue more shares to acquire the other company, management can exercise the put option to recoup the loss.

Situation 4 – Friends Company thinks that interest rates will rise in the near future, and the company currently holds a fixed-interest bond. If interest rates go up, the bond will lose value. Management can enter into an interest rate swap arrangement in which they pay a fixed interest payment in exchange for a payment based on a variable interest rate.

3. Hedge accounting

Accounting for derivatives is fairly complicated. The derivative is always shown on the balance sheet at fair value. It could be an asset or a liability depending on the underlying. For example, if a company enters into a forward contract to sell euros and the euro goes up in value, the forward contract is a liability. The company will lose money by selling the euros for less than they could have without the contract.

How a company recognizes changes in the derivative’s fair value depends on what it is being used for. Some changes are reported directly on the income statement, while others become a part of other comprehensive income. Exact details and journal entries are beyond the scope of this article.

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