Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 4

Using Forward Contracts to Manage Risk

Firms face price risk in their input markets and their output markets. Price risk exists because the future price of the inputs and outputs are unknown today. Price changes in the input market or output market can adversely affect a firm's bottom line.

Forward contracts are routinely written to help shift price risk on commodities such as crude oil, heating oil, copper, grains, and livestock. However, forward contracts are not limited to commodities. Forward contracts can also help firms protect themselves against adverse changes in interest rates or adverse changes in foreign exchange rates.

Forward contracts provide firms with an efficient means to manage price risk. The main advantage of forward contracts is their flexibility. Forward contracts can be structured for nearly any firmspecific situation that requires protection against adverse price changes. This is a terrific advantage. A disadvantage of a forward contract, however, is that the firm is bound by the terms of the forward contract even when prices move advantageously. Another disadvantage is the risk that the counterparty to a forward contract will default. That is, the counterparty may not live up to the terms of the contract.

In this chapter, we illustrate how forward contracts are used to shift risk. We start by showing how commodity price risk can be managed. Then we demonstrate how forward contracts can be used to manage interest rate risk and foreign exchange risk. Much of the material in this chapter also describes how futures contracts can be used manage risk. Only the discussion of forward rate agreements (FRAs; see Section 4.2) and their use in managing interest rate risk is specific to forward contracts.


4.1 USING FORWARDS TO MANAGE COMMODITY PRICE RISK

4.1.1 Buying Forwards to Hedge Against Price Increases

The user of a raw material faces the risk that the price of that commodity will rise. For example, many industrial firms require crude oil as an input to their production processes. If the price of crude oil rises, then these firms' costs will rise. All else equal, this will lower profits and lower firm value. An elementary income statement is:

Revenues = output price x units sold

Costs = input prices x input units purchased Profits

Unless the firm can pass the higher costs on to consumers in the form of higher output prices, its profits will be eroded by higher input (crude oil) prices, and this will cause a drop in firm value. Figure 4.1 illustrates the input price risk faced by a user of a raw material.

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