Risk Management

Derivatives demystified

Published: May 2024

Managing risk is a critical concern for treasurers. One way to manage exposures is through the use of derivatives instruments – so how essential are derivatives when it comes to managing risk? And to what extent are treasurers concerned about their complexity and possible risks?

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Protecting the organisation from risk is a key concern for corporate treasurers. And when it comes to managing risk exposures, treasurers have several options available to them. They can choose to do nothing; they can hedge the exposure naturally – for example by offsetting a foreign exchange exposure against receivables in the same currency – or they can take action in order to manage the exposure.

In the latter case, one option is to use derivatives to hedge risk. In a nutshell, a derivative is a type of financial contract between two or more parties, which can be traded either on an exchange or over-the-counter. Common types of derivatives include forward contracts, futures, options and swaps:

  • Forwards are contracts that are privately negotiated between two parties to buy or sell an asset on a future date, at a price agreed in the present (the strike rate). In the context of foreign exchange, this could mean agreeing the exchange rate today for a foreign exchange transaction in four months’ time.

  • Futures likewise allow two parties to buy and sell an asset on a specific future date for an agreed price.

  • Options give buyers the right to buy or sell an asset on a future data at an agreed price – but unlike forwards, the buyer is not obliged to buy or sell the asset when the time comes. As such, a premium is paid.

  • Swaps are derivative contracts in which two parties exchange the cash flows or values relating to specific assets for a period of time. For example, a company might use a swap to turn fixed payments on debt bonds into variable rate payments.

While derivatives can also be used for speculative purposes, in the context of treasury they are used to mitigate a variety of risks, such as foreign exchange risk, interest rate risk and commodity risk.

As Jason Teo, Head of Treasury, South East Asia at LOGOS Group, explains: “We have been adopting a prudent capital management approach, and risk management serves as a bedrock of treasury management in LOGOS. We tend to seek for natural hedge (onshore debts) and enter into interest rate derivatives (swaps, caps, collars) to mitigate FX and IR risks respectively.”

Teo explains that the company has policies in place to provide guidance and avoid “speculative and emotional play” when markets are unfavourable and uncertain. “As an advocate for risk management, hedges entered previously were all in-the-money during this high interest rate environment, resulting in lower interest expense for the company,” he adds.

Harnessing derivatives

While derivatives play a key role in financial risk management, it’s important to understand how and when to use them – and equally, that derivatives are not always needed. As Agustin Mackinlay, Senior Financial Writer at currency management automation software provider Kantox, points out, “Risk management is also about delaying the need to use derivatives – and even avoiding them altogether.” If, for example, interest rate differentials between currencies are not favourable to the firm, “treasury teams can to some extent delay the execution of derivatives transactions.”

In other cases, companies may be able to net out mutually offsetting positions, thereby avoiding the need to carry out derivatives transactions. “This allows companies to save on trading costs, and possibly to reduce financial costs derived from having to set cash aside as collateral for derivatives transactions,” Mackinley notes.

With a thorough understanding of all aspects of the business, he says the use of derivatives can be a great way of actively embracing different opportunities in what is an “incredibly dynamic world”. But on the flipside, he notes that the misuse of derivatives can wreak havoc on a firm’s financial results and reputation.

“Derivatives should only be used in the context of hedging an underlying exposure that arises from a real commercial/financial transaction,” says Mackinley. “With hedging, the value of a derivatives instrument changes in the opposite direction of the change in the underlying asset/liability. If one goes up (down) in value, the other must go down (up) in value, by exactly the same proportion. When that relationship is not clearly established, the firm may be engaging in potentially costly speculative activities.”

In recent years, technology has opened up new ways of using derivatives. “Financial derivatives instruments as we understand them have been in use for the better part of the last four decades now, although some versions are much older still,” says Mackinlay. “Perhaps the biggest change in their use is driven by technology. The same instruments – for example, currency forwards – can be used to implement programmes that would have been considered too resource-intensive just a few years ago.

“This is the case of a ‘layered’ FX programme involving many currency pairs, or a micro-hedging programme that can execute thousands of derivatives transactions in different currency pairs, with markups by client segment and currency pair, and automatic management of interest rate differentials.”

But while derivatives can be a valuable tool for managing risk, there are a number of reasons why companies may decide against using them.

Chris King is the former group treasurer of Drax Group and co-founder of corporate finance and risk management firm Dukes & King. He observes that while the use of derivatives can seem complicated, costly or even perceived as taking additional risk, “this usually stems from either a lack of understanding, and/or stakeholders coming across derivatives perhaps being used in suboptimal ways in their previous roles.”

As King explains, “Clear, upfront communication can usually help bring internal stakeholders on the journey of understanding earlier and bring out any potential headaches allowing time to address them.”

Derivatives in a low-volatility market

In practice, companies are not always proactive when it comes to making full use of derivatives. According to King, the last year has seen a theme of reduced volatility in most major markets, including equities, bonds/rates, credit and FX. That said, markets can shift quickly, with recent developments including a rapid increase in equity volatility pricing (VIX).

During a period when the price of derivatives has been at or close to historic lows, King says there has been a clear opportunity for companies to use options to protect their near-term cash flows or enable future strategy. “For example, a business exposed to GBPUSD weakening might be able to protect the medium or long-term at levels that had only been cheaper only 1% of the time, historically speaking,” he says.

But despite this opportunity, actual transactions or flows into risk protection have remained at all-time lows. King argues that there are a number of possible explanations for this juxtaposition.

For one thing, many companies survived the pandemic despite a lack of planning for an event of this kind. “This possibly also gave a sense of futility in planning for future events, and a feeling that there is little point in doing so until an event materialises,” muses King. Meanwhile, muted volatility post-Covid means that many protection strategies will have likely expired worthless, causing stakeholders to question their value – although as King notes, people are not unhappy if an annual car insurance policy expires without an accident having taken place.

A further consideration is that trying to determine the most appropriate structure and risk approach can be daunting, given the large number of approaches available. “Even if the treasurer has the requisite skillset to come up with a narrower range of structures, the board or internal risk team may not have the capability to respond to them,” he adds.

In light of these stumbling blocks, King notes that treasurers should consider the following questions when looking at a protection strategy:

  • What does the business plan sensitivity modelling indicate, and which derivatives could be undertaken to protect the firm and put it in a position of strength?

  • How can you get engagement from stakeholders for any protection strategies?

  • Where advisors are concerned, what resources do you have available to help consider the overall strategy, structuring or execution? This may include internal resources, external advisors or banking specialists.

Derivatives in practice

“All of Wolters Kluwer’s treasury activities, including the use of derivative financial instruments, are subject to a policy of risk minimisation,” says George Dessing, Executive Vice President, Treasury & Risk at Wolters Kluwer, which provides information services and solutions for professionals.

Dessing explains that the company uses derivatives to mitigate currency risks and interest rate risks, noting that “the group does not purchase or hold derivative financial instruments for speculative purposes” – rather, the purpose of these hedging activities is to reduce financial risks faced by the company. “Derivates are important in fulfilling our objective of risk minimisation, but Wolters Kluwer believes: ‘the simpler the better’,” he adds.

Where currency risks are concerned, Dessing notes that Wolters Kluwer identifies transaction and translation risks, with the transaction risk exposure within individual group entities seen as “relatively immaterial”.

“The transaction prices invoiced to customers for goods and/or services are mainly denominated in the customers’ local currencies,” says Dessing. “Given the nature of the business, almost all related costs are also incurred in those local currencies. Derivative financial instruments to hedge transaction risks are therefore rarely used by the company.”

While complex derivatives are sometimes needed to solve complex issues, Dessing notes that it is vital to fully understand the mechanisms of a derivative, given that the value of a derivative can fluctuate strongly over time. “You may need to modify or close a long-term derivative contract in the future, and you need to be aware of the variables that can influence the result,” he adds. “In some cases, it may even be very unfavourable to close the derivative contract.”

On another note, Dessing notes the importance of being able to communicate clearly about derivatives with internal and external stakeholders, such as the accounting department, tax, investor relations and auditors. “They may not have the same understanding of these products as you have, and entering into a derivative contract may have implications for their disciplines,” he observes. “As we say in Wolters Kluwer, ‘We are winning as a team, and we’re stronger together’, whereby we collaborate and share knowledge across disciplines.”

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