The conventional wisdom held by the public is that futures and other derivatives are "weapons of financial mass destruction" that are a source of considerable risk for companies and investors. While there is some truth in this statement, large multi-national corporations that use these financial instruments responsibly can decrease risk in conducting business operations by protecting the value of assets, liabilities, revenues and cost inputs. (Want a solid understanding of futures contracts are, how they work and why investors use them? Check out Futures Fundamentals.)
IN PICTURES: 5 Reasons For Corporate Thanksgiving
Disney Downs Currency Risk
Many large corporations use derivatives to hedge risk because it does substantial amounts of business overseas, and are paid in currencies other than the U.S. dollar. These holdings of foreign currency are not always repatriated to the U.S. immediately, and can reach considerable size.
Let's use Disney as an example. Disney has considerable operations in Europe, Asia and other international locations and uses derivatives to hedge its exposure to the euro, the British pound, the Japanese yen, and the Canadian dollar.
Disney uses option and forward contracts to hedge its exposure out as many as five years. The company uses the gains and losses on these contracts to offset the change in the U.S. dollar equivalent of these foreign currency holdings. (Before entering this market, you should define what you need from your broker and from your strategy. Don't miss Getting Started In Forex.)
Intel's Interest Rate Risk Reduction
Many companies have assets or liabilities on its balance sheet that it wants to protect from a change in interest rates and it can do so with derivatives.
Intel uses interest rate swap agreements to hedge its holdings of fixed-rate debt instruments that have maturities of more than six months. The company swaps its fixed rate payments into three-month U.S. dollar LIBOR-based returns.
Intel reported a $1.7 billion notional amount of interest rate swaps as of the end of 2009.
Anadarko Protects Revenue
Other companies use futures and other derivatives to hedge risk because the products they sell are commodities whose price is subject to volatile fluctuations in price. Futures and derivatives are used to fix the revenue that the company will receive for the commodities its sells.
Energy companies are heavy users of various futures and other derivatives to hedge this commodity risk. Anadarko Petroleum is one of the largest independent oil and gas companies with properties in the Gulf of Mexico, the onshore U.S, and other areas. The company expects to produce as much as 231 million barrels of oil equivalent (BOE) in 2010, and uses hedges to lock in a range of prices for the oil and natural gas it sells.
Anadarko Petroleum currently has 69% of its oil volumes hedged in 2010 at various prices. This percentage drops to 34% for 2011. Natural gas volumes are also hedged, and Anadarko Petroleum has 75% of its deliveries hedged in 2010, and 25% in 2011. (Find out how the everyday items you use can affect your investments in Commodities That Move The Markets.)
Other companies are heavy users of commodities to conduct business operations. Alcoa is a major producer of Alumina and metal products, and 29% of its total refining production costs are from power generated by fuel oil or natural gas. The company uses futures and forward contracts to protect itself from unanticipated increases in these commodity prices.
The Bottom Line
Futures and other derivatives are vital tools for companies to reduce risk in business operations and are used as a hedge against a change in value of assets, currencies, revenues and the cost of production inputs. There shouldn't be any worry as long as they are used to hedge and not speculate.
Catch up on the past week's top financial news in Water Cooler Finance.