Hedging and Its Importance to the Securities Research Paper

Excerpt from Research Paper :

Hedging and Its Importance to the Securities Markets

In simple terms, hedging is a form of insurance. It is a mechanism used to help shield investors and companies from the negative occurrences within the ordinary business environment. If properly hedged, when negative events do affect a business or individual, the damages incurred will be significantly less. A common example is that of insurance on an automobile or house. In the event of a catastrophic wreck or fire, and depending on the level of insurance purchased, an individual can recover the value of the lost car of home. In exchange for this reassurance, the individual would be required to pay monthly premiums whether or not the event actually occurred. In essence the individual is hedging him or herself against the likelihood of an event that would negatively impact the value placed on the particular car or home. Similarly, companies also hedge to reduce the impact of environmental factors on their business. For example, the airline industry is notorious for hedging against rising fuel and commodity prices. Hedging is so important within this industry that often, the company that can hedge more efficiently is frequently the most profitable company. Usually, when hedging, the instruments used have negative correlations. Correlation coefficients are used to determine the movements of two instruments when one instrument remains constant. The measurements are between negative one and positive one. A correlation coefficient of 1 means the instruments move in tandem with one another. A correlation coefficient of negative one means the instruments move in opposite directions, while a correlations coefficient near zero means there is no established relationship. Noting our previous example of the home and home insurance, the correlation between these two instruments would be near negative one. As the value of the house declines due to a catastrophic event such as a hurricane, the value of the insurance policy increases. Below is a simple chart depicting these movements.

Value of Home ($250,000)

Value of Insurance Policy ($0)

Value of home appreciates over the Value of policy remains constant

Holding Period

A negative event occurs such as a fire, hurricane, flood, or earthquake which destroys the home.

Value of Home ($0)

Value of Insurance Policy ($250,000)

Home is destroyed and has no value

Homeowner can now claim funds from policy

As can be seen from this example, hedging plays an important role of guarding against potential losses whether for an individual investor, corporation, or government.

Finally two commonly used hedging strategies used by companies are options and futures contracts. These instruments are used heavily be commodity intensive industries to keep the price of commodities fixed. For example, individual investor purchases shares of Unilever and wants to protect themself from the downside risk associated with the stock. The individual may enter into a put option which allows the individual to sell at a predetermined price. If the stock falls below this predetermined price, the investor in unaffected because of the prior price agreement. Similarly, Unilever may want to protect itself from the price volatility of tea used to produce its Lipton Ice tea product. In order to accomplish this, Unilever may decide to enter into a futures contract. This futures contact allows Unilever to purchase tea at a predetermined price in the future. This can be either a disadvantage or a superior competitive advantage for Unilever. If for example, the price of tea skyrockets, then the hedge would have been profitable. However, if the price of tea declines, Unilever is still obligated to pay the contracted price for the goods even if it's at a higher price. Over the course of this document, I will explain how Unilever uses hedging as a means to remain profitable in a global business environment.

Brief Company Overview: Unilever

Unilever is a home care, personal care, and food products supplier and distributor established in 1890. It has over 400 brands including Lipton and Slim Fast. These 400 products contribute to over $1 billion in sales annually. Unilever is global companies with more than 53% of its sales in overseas markets. It is also a very socially conscious company with many of it initiatives aimed at providing better quality of life for all stakeholders involved, especially those in emerging markets. In fact, many of Unilever's products have a social mission attached to them. For example, the product Lifebuoy is aimed to promote better hygiene practices through hand washing in emerging nations.

Through both a social responsible and consumer driven business model, Unilever has achieved financial and social success for over 100 years.

How Unilever uses futures and other derivatives to hedge against rising costs

For purposes of this paper, we will discuss how Unilever uses hedging to continue its profitable operations within the North American market. To begin, commodity prices essential to the general operations of Unilever have been rising over the course of the last few years. The first and arguable most important of these commodities is fuel. Being a global company with 53% of its revenue stemming from overseas markets, Unilever depends heavily on transportation. This comes in the form of freight, boat, trucks and other methods of transportation. Below is a chart depicting fuel price increases from 2006. As depicted by the chart, gasoline prices have recently plummeted which is an advantage for Unilever and its global operations.

Chart I: Gasoline Price Volatility

Another important element to the Lipton Ice tea product is sugar. Like gasoline, sugar is yet another commodity susceptible to price volatility. Below is a chart depicting sugar prices over the last year. As noted by the chart sugar prices are too falling. The question is, by how much have sugar and gasoline prices fallen. The third chart below depicts both commodities superimposed upon one another.

Chart II: Sugar Price Volatility

Chart III: Sugar and Gasoline price volatility

From the three charts above, we can see that gasoline prices have increase 13.7% over the course of this year alone. Meanwhile, sugar prices have dropped nearly 20% over the same period. From this brief and subtle amount of information, we can infer that gasoline prices may need to be hedged to help remedy price volatility. Likewise, it may be advantageous to allow sugar prices to drop as they currently are. However, the future is unknown. Due to this uncertainty Unilever may instead enter into futures contracts for both commodities in order to have a constant budgeted amount in regards to commodity prices.

Finally, in regards to the Lipton Ice Tea product line, we must also consider world tea prices. As with gasoline, Tea prices across the world are increasing. In fact, Tea prices have nearly doubled from there 2003 low. As a result, Unilever may also want to engage in futures or options contacts to help mitigate this risk

Unilever's Hedging Strategy

As apparent form the four charts above, it is now, more important than ever for Unilever to hedge against this volatility. First, rising commodity prices are reducing the margins on many of its North American products. When margins are reduced at a faster rate than sales, profitability is diminished. As a publically traded company, investor's desire continued sustainable growth commensurate with the risk taken for a given security. If Unilever fails to deliver the results investors' desire, the stock price may soon plummet as investors leave to more profitable endeavors. In an effort to help avoid this risk Unilever engages in various hedging strategies discussed in its financial statements. In terms of its financial statements Unilever values all derivatives at fair value, which are reflected in the earning report. In addition, gains and losses from derivative contracts are recognized in the immediate period in which they occurred. Unilever does not use derivative financial instruments for speculative purposes. Instead, Unilever, according to the financial statements…

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