Use of Derivatives in a Chosen Company Research Proposal

Excerpt from Research Proposal :

derivatives in general and discusses their use by Rolls-Royce plc in its risk management programme.

Derivatives derive their value from an underlying financial instrument and as such, they allow a way of accessing and trading in the value of the underlying instrument without needing to put up the full value of that underlying instrument. Derivatives can be used for a number of purposes, including leverage, hedging, income generation and profiting from long and short positions (Wise Owl, n.d.).

Companies like Rolls-Royce use derivatives for hedging risk, allowing them a form of insurance. Typically companies use derivatives as a tool within a risk management program. Recent research shows that more than 90% of large U.S. companies use derivatives regularly (Brigham and Houston, 2009, p. 581). Hedging allows managers to focus on running their core businesses without needing to worry about variability in interest rates, currency, and commodity prices.

Rolls-Royce uses hedging for these purposes. According to the company's 2011 annual report, Rolls-Royce used various financial instruments in its efforts to manage exposure to movements in foreign exchange rates. The company used commodity swaps to manage its exposure to movements in the price of jet fuel and base metals. To hedge the currency risk associated with a borrowing denominated in U.S. dollars, the company used currency derivatives. To manage its exposure to movements in interest rates, the company used interest rate swaps, forward rate agreements and interest rate caps (Rolls Royce, 2012).

Companies may pursue other risk management alternatives as well. Once the decision has been made to manage a given risk exposure, the manager must evaluate the effectiveness of various risk management alternatives by analyzing the associated risks, along with the costs and benefits of each. Generally speaking, there are two main alternative risk management categories to consider in addition to derivatives, policy decisions and cash market transactions.

Policy decisions include those business policy decisions that a company's management makes as part of their on-going effort to reach their competitive position and financial performance objectives. Policy decisions tend to be the least costly to put into place, but they also tend to be somewhat limited in their usefulness for managing all the exposure to be managed without eliminating the potential for profit. Even so, this alternative should be exhausted before moving to derivatives (Strategies and Tactics, 2006).

The other risk management alternative, cash management transactions, includes conventional transactions that a company's management uses to manage the company's balance sheet in conformance with regulatory guidelines and industry practices. In the case of financial institutions, these transactions are typically money market, fixed income, mortgage backed, and equity securities related transactions. It is best to use these alternatives when there is still exposure remaining to be managed after policy decision alternatives have been exhausted but before using derivatives. Derivatives, the remaining risk management alternative, tend to have more inherent risks, and should be used only when there is risk remaining to be managed after policy decision and cash market transaction alternatives have been exhausted (Strategies and Tactics, 2006).

Even though a company's management may make a conscious decision to manage a given amount of risk exposure and may pursue exhausting all policy decision and cash market transaction alternatives, it is possible that some exposure may still remain to be managed. When this happens, managers must focus on evaluating the risk/reward profile associated with using derivatives to manage the remaining exposure. This evaluation occasionally will show that the risks associated with using a derivatives-based strategy may actually exceed the benefits of attempting to manage the remaining unmanaged exposure. Consequently, in some instances there is no practical alternative to managers other than continuing to accept the unmanaged risk exposure (Strategies and Tactics, 2006).

To be effective, derivatives must be used as part of a strategy. How well a derivative strategy works will depend upon the use to which it is applied, hedging or speculating. According to most analysts, hedging is considered to be good while speculating in an effort to increase profits is considered to be bad. While hedging is accepted business practice, it is expected that firms use it primarily to manage exposure to risk.

Given the benefits of hedging, sophisticated investors and analysts demand that firms use derivatives to hedge certain risks. One such example happened with Prudential Securities reducing its earnings estimates for Cone Mills, a North Carolina textile company, because Cone did not sufficiently hedge its exposure to changing cotton prices. Any company that can safely and inexpensively hedge its risks is expected to do so (Brigham and Houston, 2009). In scenario, hedging or speculating, the goal must be prudent risk management of the underlying security. Like all corporate decisions, risk management decisions should be made on the basis of a cost/benefit analysis.

The use of derivatives by non-financial organizations is growing. The Organization for Economic Co-Operation and Development (OECD) noted significant growth in recent years in the use of derivative instruments in both mature and emerging market countries. The OECD noted the rapid growth in derivatives in global markets, including interest rate and foreign exchange derivatives and credit default swaps. Their interest in growing derivative use included policy, operational, and regulatory issues relating to the use of derivatives (OECD, 2007).

Derivatives have received extensive news coverage lately because of their role in the recent financial crisis. Large financial firms took on too much risk, that is leverage, in the process using complicated instruments in opaque trading environments, thereby contributing to the crisis. But derivatives are also making news because of the massive increase in trading in commodity derivatives over the past decade. The growth reflects a trend by institutional commodity managers adding commodity derivatives as an asset class to their portfolio. This addition was part of a larger movement in portfolio strategy shifting away from traditional equity investment toward derivatives based on assets such as real estate and commodities. This is a relatively recent phenomenon wherein institutional investors increasingly used commodity futures to hedge against stock market risk (Basu and Gavin, 2011).

The threat of proposed derivatives regulation shows how important a risk management tool they are. Non-financial companies such as Rolls-Royce that use derivatives to reduce operational risk would be severely impacted by changes to regulation of derivatives contracts. Proposed regulation under earlier consideration would have shifted all derivatives contracts onto exchanges.

Because Rolls' revenues are in dollars and most of its costs are in sterling, they require foreign exchange hedging. On Rolls' 2009 balance sheet, foreign exchange derivatives totaling £14.5bn ($22bn) are reported. Their fair value fell by £2.6bn in 2008 before rising £2bn in 2009. Given that Rolls had a net equity of only £3.8bn at the time, under proposed regulation it would have had to devote two-thirds of its balance sheet to margin payments rather than making engines (Jackson, 2010).

Under current regulations however the £2.6bn charge does not apply to Rolls' banks. Since they are in the business of matching their positions, they need only post margin on the net difference. They are both ways in the market, unlike financial users (Jackson, 2010).

As a result of the financial crisis, corporate derivatives users like Rolls-Royce, who had no role in creating the crisis, have found themselves embroiled in post-crisis attempts to restructure the over-the-counter (OTC) market. Proposed rule changes would have forced companies such as Rolls-Royce to use clearing houses and possibly even stop hedging altogether.

Faced with such a threat, the company stepped into the fight, lobbying regulators to make sure that proposed regulation did not cripple Rolls-Royce operations, including their ability to hedge risk. Non-financial users like Rolls found that they needed to protect themselves from regulation designed primarily to protect investors. The majority of corporates transact on an uncollateralized basis, but clearing requires the posting of initial and variation margin to offset changes in the mark-to-market value of a trade, which enables the two counterparties to transact on a secured basis (, 2012).

Acceptable initial margin is set by the rules of each clearing house, and is restricted to safe, liquid assets such as cash, government bonds and gold; variation margin must be paid in cash. Corporates typically do not have a stockpile of such assets, and would have difficulty coping with the up-and-down demands that would occur with a large portfolio of cleared OTC trades (, 2012).

Mandatory clearing would create a massive liquidity risk for Rolls-Royce if they had to post collateral. As Iain Foster, Rolls-Royce mergers and acquisitions manager points out, "We would have had a significant risk of insolvency if there was another crisis, unless we changed our financial hedging" (, 2012). If margin calls grew too large, the company would have to consider canceling hedges, which would crystallize losses and expose them to market risks again. Foster called that scenario "obviously crazy." Rolls won at least a partial victory in September 2010 when the European Commission proposed its version of clearing legislation, European Market Infrastructure Regulation (Emir), that contained an exemption for non-financial entities that use…

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