Beyond banks: Financial derivatives and the value of non-financial firms
April 03, 2014
For top-tier banks, financial derivatives are part of the contemporary toolkit for mitigating the risks involved in complex transactions. But non-financial firms are major players in the derivatives market as well. Cash flow volatility, which can arise from adverse changes in interest rates, foreign exchange and commodity prices, can rob these firms of the liquidity needed to meet fixed costs.

Derivatives such as forwards, futures, swaps and options are designed to help corporations and investors hedge, or mitigate, these risks and limit their vulnerability to financial distress.

Furthermore, hedging the volatility of cash flow and profits cuts borrowing costs and can reduce tax liability. Broadly speaking, these benefits tend to enhance the value of the firms that use derivatives. A key goal of the recent Milken Institute report "Deriving the Economic Impact of Derivatives" was to quantitatively assess the relationship between derivatives use and firm value and gauge the effect on real economic growth.

Case studies in the airline, energy, and food-processing industries illustrate how financial derivatives are often used. In their 10-K filings, companies report these instruments' impact on pricing, output, supply chains, and other factors. The statistics show that many firms in these key sectors saved hundreds of millions of dollars in costs or enjoyed other net gains in the course of a fiscal year by participating in this market.

In the airline industry, for example, fuel is often the largest operating expense. The ability to manage volatile fuel costs is widely viewed as the key to stabilizing net cash flow. Indeed, United Airlines calculated that a $1 increase in the price per barrel of jet fuel would raise annual operating expenses by $95 million. In 2011, six of the seven major U.S. airlines used derivatives based on jet-fuel correlates to manage risk, including exchange-traded and over-the-counter products. In a year of rising fuel prices, that investment paid off big-time. Three of those carriers--United, Delta, and AmericanaEUR"saved a collective $1.2 billion.

Considering these gains, it may not come as a surprise that investors typically assign higher valuations to firms that use them than those that don't, our statistical analysis shows, which boosts these companies' ability to expand operations. The impact doesn't end there, as higher firm value and vigorous reinvestment have implications for the real economy. Derivatives use by firms added about $1 billion per quarter to real GDP from Q1 2003 to Q3 2012, the data demonstrate.

It's worth emphasizing, however, that these instruments meant to manage risk carry risk themselves. Hedging is different from speculation. If that distinction is ignored, large, unpredictable losses can be the result, as demonstrated during the financial meltdown that jolted the global economy in 2008. Prudent, careful use, with full consideration of a company's exposure to financial risk, should be the rule.