The fundamental concept of risk is that there are more scenarios that can occur than will actually happen. (Michael Durbin, All About Derivatives 71 (2d ed. 2011).) To deal with this uncertainty, companies may consider establishing a risk management program to reduce the probability of financial loss, to reduce the amount of financial loss, to safeguard against product shortages, or to achieve a combination of any of these goals. (Id.) A comprehensive risk management program will often incorporate the use of financial derivatives to manage these risks.
For example, a power producer that utilizes natural gas to generate electricity may decide to sell the electricity it generates at a fixed price. Under this scenario, the power producer is exposed to fluctuations in the price of natural gas. If the price of natural gas increases, the cost of generating electricity also increases. If the cost of generating electricity exceeds the fixed price for which the power producer has agreed to sell its generation, the power producer would incur a loss.
To mitigate this loss, a power producer can use a derivative that hedges against an increase in the price of natural gas. This is how this type of hedge would work in practice: When the power producer enters into a contract to purchase natural gas to be delivered on a set date that is three months in the future at the prevailing spot price on the date of delivery, the power producer would simultaneously take a "long position" in (in other words, agree to buy ) natural gas futures contracts in an amount equal to the amount of natural gas the power producer intends to purchase, with a settlement date that is also three months in the future.
On the settlement date (in this example, three months later), the spot price of natural gas and the price of natural gas futures contracts should have converged. Any difference between the price paid by the power producer for the futures contracts and the price of the futures on the settlement date would be financially settled. Assuming that the spot price of natural gas and the price of the futures contracts have converged, and that the spot price of natural gas has increased, the power producer would receive a payment in an amount equal to the difference between the price it paid for the natural gas futures contracts and the spot price of natural gas on the delivery date. In this way, by using natural gas futures, the power producer will have effectively paid the spot price of natural gas as of the date it entered into the agreement to purchase natural gas. The power producer's simultaneous purchase of the futures contracts essentially wiped away its exposure to an increase in the price of natural gas.
This is just one example of how the well-planned and well-monitored use of derivatives can help companies successfully manage risk. However, a number of issues must be considered to determine if such a program is right for your company. The following questions should be carefully considered and are intended to help guide corporate counsel whose companies are considering developing an in-house risk management program that uses financial derivatives. Companies seeking to develop an in-house hedging program are encouraged to seek guidance that is tailored to their unique facts and circumstances.
An in-house risk management program takes a significant amount of resources, in terms of both human and financial capital. Companies must understand the amount of time and money that is required to engage in derivatives trading, and then decide whether they are willing to dedicate the necessary resources to an in-house risk management program. Among other things, dedicated human capital is needed to enter into the necessary trading agreements, to execute trades, and to ensure compliance with a host of regulations that apply to this type of activity. Companies have obligations under U.S. laws and, depending on a company's location and the location of its counterparties, companies may also have cross-border regulatory obligations. In addition, derivatives trading often requires a dedicated amount of working capital on hand to cover any margin calls resulting from changes in the value of the derivatives to which a company is a party.
Companies that trade derivatives as part of an in-house risk management program will need employees who have trading knowledge, market knowledge, regulatory knowledge, and an understanding of how derivatives regulatory obligations interact with obligations in other areas of law, such as securities and tax. A company may have this type of existing expertise, may choose to develop such expertise, or may choose to recruit the requisite personnel. Any of these options requires careful planning, and a significant investment of time and money.
Because the derivatives markets and the regulatory regimes governing them are constantly evolving, companies that establish an in-house risk management program will also need to establish and maintain a continuing internal education program. Companies may choose to facilitate such a program through webinars, in-person training sessions, written materials, or a combination of these approaches. Whichever platform is used to provide continuing internal education, the company should ensure that the messages delivered are clear, consistent, and tailored to address the company's particular program activities.
Companies must determine the regulatory obligations that will result from derivatives trading. Most often these obligations include recordkeeping, reporting, and trade documentation. While the exact requirements that apply will vary depending on the instruments used, a company will need to draft and implement policies and procedures to address the company's compliance with each of the applicable regulatory obligations. A company will also need to establish internal reporting practices. All of these components are necessary to avoid potential civil and criminal liabilities.
Once a company decides that it is ready and willing to dedicate the time and money needed to develop an in-house risk management program, the company needs to think long and hard about which risks it will hedge through its program. Even those companies with well-established in-house risk management programs do not hedge all of their risks. The most common risks that are mitigated through the use of financial derivatives are interest rate risk, credit risk, price risk, basis risk, and currency exchange risk.
There are a variety of derivatives instruments available to help companies achieve their desired risk management profiles, including futures, options, swaps, and swaptions. Depending on the types of derivatives used, companies may be able to engage in derivatives trading either on-exchange or off-exchange. Each type of derivative instrument has its own advantages and disadvantages that a company must explore. The decision about which instruments a company will use will also guide a company's need for master agreements and other trade documentation. Depending on the type of agreement that is needed, negotiations with a company's desired trading partner can take weeks or months.
When setting its risk management guidelines, a company should consider:
When should risk be managed and when should it be accepted? Who will trade derivatives? How much can be traded in terms of volume and value? Can the derivatives transactions be long-term, short-term, or a combination thereof? How will the company manage basis risk (i.e., the risk that the company's hedges and exposures do not match up)? How will the company distinguish between hedging and speculating? Will the company permit the use of options? Is the company seeking only to manage risk or also to make a profit? How will the company monitor the risk associated with its derivatives activity
While derivatives may be used to hedge a company's risks, the use of derivatives also carries numerous risks, including counterparty credit risk, liquidity risk, and regulatory risk. Each of these risks can be mitigated in various ways. For example, counterparty credit risk can be mitigated by developing and implementing policies and procedures governing the types of counterparties with which a company may trade. A company's policies and procedures may also establish minimum credit standards and set collateral thresholds for a trading partner or require certain representations or margins from a trading partner. A company should also establish a means of actively monitoring the creditworthiness of its trading partners.
Companies should consider formal and informal ways to monitor compliance with their own program rules and with all applicable regulations. Formal methods may include internal reporting requirements, routine self-audits, and whistleblower incentives. Informal ways to help ensure compliance may include fostering a culture of compliance at the company and encouraging reporting of potential violations.
How will the company assess the effectiveness of its derivatives?
If financial derivatives are used to hedge a company's risk, it is important to determine their effectiveness. To assess the effectiveness of a risk management program that uses derivatives, a company should consider the losses mitigated or incurred, the amount of resources dedicated to developing and maintaining derivatives use, and whether internal and regulatory compliance was achieved.
The use of derivatives requires a significant investment of time and resources to ensure that the instruments used have their intended effects, that exposures to the company are limited, and that applicable laws and regulations are followed. With that said, the use of derivatives can be a very effective tool for companies to use to hedge or mitigate their commercial risks.
- David W. Edwards, Energy Trading and Investing (2010).
- The Institute for Financial Markets, Introduction to Futures and Options (2002).
- ACC Legal Quick Hit: Developing an In-House Hedging Program (Nov. 20, 2013).
- CME Group Web Presentation: Understanding Contract Specifications (Jan. 28, 2011).
- Ivilina Popova and Betty Simkins, The Value of OTC Derivatives: Case Study Analyses of Hedges of Publicly Traded non-Financial Firms (ISDA Study, March 2014).