Hedging strategies in securities markets and business risk management

¶ … 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.

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 uses foreign exchange forward contracts, interest rate swap contracts, and forward rate agreements to hedge exposure. Unilever also uses commodity contracts to hedge raw materials. These contracts require Unilever to deposit cash and/or collateral for these derivative obligations. As of 2008, the collateral amounted to 208 million euros which was a 161 million euro decrease. In regards to foreign exchange forward contracts, Unilever engages in these instruments on a case by case basis. Unilever does not have a foreign exchange policy that requires managed trading and financial foreign exchange exposure. Further, all of Unilevers financial statements and performance records are published in Euros. As mentioned earlier, Unilever is a global company with operations within many territories. By denominated all its assets in euros, Unilever will have some exchange rate risk when translating the underlying assets of foreign subsidiaries into euros. Unilever mitigates this by borrowing in the local currency of the country in which it operates. If, management for whatever reason determines that the retranslation risk is high in certain countries, it will engage in forward foreign exchange contracts. This is especially important, because if assets are not properly hedged, it may result in unusual balance sheet performance.

Unilever also engages in interest rate swaps to mitigate the risk associated with varying interest rates. In addition to interest rate swaps, Unilever also borrows at a fixed, long-term rate as oppose to a rate that varies with time. As of 2009, 95% of all fixed liabilities had fixed interest rates. This is again very important, due to the uncertainty of future events and occurrences. By hedging, Unilever is assured a fixed interest rate on a majority of its debt.

In conclusion, Unilever recognized the immediate danger of not properly hedging against raw materials, foreign exchange and interest rate volatility. This is ever more important as Unilever is a global company with operations in very distinctive territories. As mentioned above, both fuel and tea prices are increasing at an exponential rate. Further, uncertain resulting from global operations presents a daunting task for Unilever. Unilever however has adjusted by entering in to forward contracts for certain commodities. It has also kept its interest rate fixed over the next few years as oppose to variable. Finally, it engages in foreign exchange hedges to help mitigate volatility in various countries. When combined effectively this allows Unilever's Lipton Ice Tea product to be sold profitably and effectively in almost any nation worldwide.