How do companies use derivatives to hedge their bets?

Just like individuals can use derivatives to hedge the bets, companies do the same thing. Their approach is a little more sophisticated, but a lot of the principles remain the same.

Here’s how.

Industry and System Risk

In the context of hedging corporate accounts, one of the most important factors is industry risk.

Industry risk, or “systemic risk,” is any series of factors that could affect an entire industry in one fell swoop. Examples of this include government regulation or the price of common materials.

Investors worry about industry risk all the time because it’s something that they can’t control. Business decisions and corporate leadership can be smoothed out by selecting other companies to invest in, but anyone who wants to trade a given industry has to accept the accompanying risks.

Yet, if investors worry about industry risk, the companies themselves live it and breathe it. It’s commonly said that General Electric’s accountants comprise the world’s best tax firm. That’s no accident. Since taxes represent an industry risk to the company, they pour resources into trying to control it.

Mitigation Through Investment

The problem with systemic risk is that it’s hard to control through the ordinary course of business. If something represents higher costs or more difficult marketability, greater volume won’t help. Having twice as many widgets in the warehouse will simply double your losses if they’re obsolesced overnight.

Which brings us back to derivatives. Options represent the movement of specific physical and financial components and, as a result, many companies use them to mitigate industry risk by investing specifically in commodities whose values move counter-cyclically to their own.

By investing in a commodity that it relies on, a company can make money even as its costs go up. For example, many airlines will invest heavily in oil futures. This, on the surface, would seem counterintuitive for a company dedicated to consuming as much of the product as possible, but as the price of oil rises they can offset their increased expenses through portfolio gains.

Is it perfect? Not nearly. The money made back through commodities seldom recaptures the entire amount lost through higher production prices, but it helps.

Mitigation Through Price Controls

Finally, futures contracts can control costs.

Under ordinary circumstances, a futures contract is mostly hypothetical. A supplier agrees to sell the given commodity and the purchaser to buy, but no one anticipates actual delivery. It’s just a way of expressing confidence or lack thereof in future pricing.

For big companies, though, this can be a way to lock in prices. By making futures contracts that they actually expect to receive, a business can lock in prices well in advance and thereby stabilize their model over long periods of time.

Grocers have become well known for this tactic. A chain will buy x tons, for example, of bananas at the current market price for delivery next July. Although it means they can’t profit if the bottom falls out of the produce industry, it also grants security against unexpected price hikes. Further, by using the abstract futures market, they can avoid some of the challenges that come with direct supplier negotiations.

No one loses money from having to double the stickers in the produce department. As to lost opportunity? Well, risk mitigation does come with some costs after all.