Businesses face many different types of risks.
There are risks of injury to employees, building damage from storms or product failures for your customers. Another big risk for any business is financial price risk — the risk that prices for your company’s inputs or outputs will move against you.
Many businesses, particularly large corporations, hedge these risks. Hedging makes planning easier, allowing managers to focus on their own production, not external forces such as commodity prices, currency values or interest rates.
Hedging occurs any time a firm incurs a cost to reduce the risk of these adverse price movements. A common hedge practice makes use of financial contracts called derivatives, which include forwards, futures and options.
Unfortunately, regulators continue to place a large part of the blame for the 2008 financial crisis on derivatives.
While derivatives can be used to speculate, regular businesses use them to hedge. Hedging with derivatives helps businesses control prices in their operations. Gains on derivative contracts offset any losses in the business, or real assets of the firm.
Futures contracts, for example, are sold on exchanges and frequently used to hedge price risks facing farmers or mining companies. For a small deposit, the farmer can protect against price declines by selling crop futures on its output, or a cheese producer can buy milk contracts to protect against price increases for its main input.
Derivatives don’t deserve the bad rap from regulators. Speaking to an international monetary conference in Atlanta this month, Treasury Secretary Timothy Geithner said derivative trading is too risky, and “new standards” are needed to protect the public. Proposals are being drafted by Geithner’s office that will require more derivatives to be traded on exchanges rather than individually between a bank and its customer.
While trading on exchanges is less risky, the trade-off here is a much higher cost for hedging because firms will be unable to tailor the hedge to their particularly need. Local companies likely will face higher costs for their various hedging needs. Idaho Power uses derivative contracts such as forwards and swaps to manage its exposure to price risk in the electricity market. Micron Technology uses derivatives to manage the risk of currency devaluations in the global market where it does business. Idaho Power’s program can reduce the need for frequent electric rate changes to consumers. Micron’s program reduces volatility in earnings, potentially reducing the need for layoffs or other interruptions in their operations.
Trading on regulated exchanges will make the derivative market more transparent, increasing the efficiency of this financial market. However, the cost of this regulation will be borne by legitimate businesses hedging legitimate risks. Furthermore, the regulation will do nothing to limit speculation.
Under the Dodd-Frank financial-overhaul law passed in the summer of 2010, regulators must have new rules for U.S. businesses in place by this July. The rush to write the rules is on. The costs of these new regulations are heading straight to the bottom line of Idaho firms.
PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa.