Companies can use hedges to offset exposure to risk. Companies like Southwest Airlines have used hedges to lock in the cost of fuel for their airplanes; this reduces the risk of fuel prices skyrocketing. Companies can lock in the cost of multiple items including, natural gas, oil, currencies, electricity, interest rates and commodities. Let look at three examples of how a company could use a hedge to smooth their earnings.
Example #1 – ABC Company – Interest Rate Hedge
The ABC Company has a large debt burden, the variable interest costs on their bank and bond debt account for close to 35% of their net income. Currently interest rates are extremely low; the management of the ABC Company is particularly concerned what would happen if interest rates increase. The ABC Company could put in place an interest rate hedge; this would allow the ABC Company to secure historically low interest rates.
Example #2 – DEF Oil Company - Currency Hedge
The DEF Oil Company has light sweet crude oil production. Management of DEF Oil Company is tremendously bullish on the prospects for oil; they believe that oil will drive past $100 a barrel shortly. DEF Oil Company is located in Canada even though it sells its production to companies in the United States. Management at DEF realises that an increase in oil will lead to a higher Canadian Dollar, which will offset some of the increase in oil. The DEF Oil Company could put in place a Canadian Dollar hedge which would lock in the cost today; this would allow the DEF Oil Company to participate in the rise of oil and not the Canadian Dollar.
Example #3 – GHI Company – Natural Gas Hedge
GHI Company has millions of square feet of storage space. The management of GHI Company uses natural gas to heat the storage space; they want to lock into the current low cost of natural gas. GHI Company could use a natural gas hedge; this would allow GHI Company to lock in the current low cost of natural gas.
How can companies put hedges in place?
The first step is for company management to seek professional advice. Management may be advised to make use of inverse exchange traded funds, options, futures, forwards and contracts for difference to hedge their exposure to risk. Most-financial instruments are flexible enough even small-hedging needs; some companies have hedged risk exposures as little as $100,000.
Hedging should be considered by all companies. Since directors and management of publicly traded companies are liable to shareholders, it is crucial for them to consider if they should use financial hedges to reduce risk. If a company is considering this, management should seek professional advice.
William McNarland, CFA has been working in the investment industry for 15 years. He is a co-founder of PMCMG Inc. and My Global Analyst Inc. He has appeared as a guest on Money Line and taught at the University of Toronto. He resides in Alberta Canada. He can be contacted at email@example.com.