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Hedging Still an Effective Tool in Smoothing Company's Cost Structure

Dinah Wisenberg Brin,|Special to CNBC.com
Friday, 30 Sep 2011 | 2:52 PM ET

Krispy Kreme Doughnuts may owe its success to the warm, glazed confections that inspire customer zeal, but the company also relies on commodity futures contractsto limit its risk from fluctuating ingredient costs and rising gasoline prices, and uses a derivative contract to hedge against rising interest rates.

Commodities traders at the New York Mercantile Exchange.
Photo: Oliver Quillia for CNBC.com
Commodities traders at the New York Mercantile Exchange.

Companies as diverse as clothing retailer J. Crew Group , restaurant chain CrackerBarrel Old Country Store and mattress maker Sealy Corp. also use swaps or other derivatives contracts to protect themselves from changes in interest rates, fuel prices, or foreign-currency exchange rates.

And hedging arrangements remain an important tool for airlines seeking to guard against rising jet fuel prices, even though the transactions can be costly and carriers risk locking themselves into above-market payments if fuel prices slide.

While derivatives themselves carry risks and financial scandals have tarnished their image, many companies use futures contracts, swaps, collars, and other hedging instruments to minimize volatility. Derivatives contracts, while diverse and often complex, generally allow companies to lock in prices or rates on underlying assets for a defined period.

“When properly used to hedge risk exposures, derivatives can substantially decrease risk," says Bud Haslett, head of risk management and derivatives for the CFA Institute. "However, when improperly used, they can cause many problems.”

Advantages and Payoffs

Companies that hedge against price or rate fluctuations have the advantage of more consistent cash flow, says Haslett. A big chocolate producer, for example, might know that it will use a million tons of cocoa over the next year, so will agree to acquire that amount through the futures market and lock in the price so it can price its products accordingly. The hedge may protect the company should cocoa prices soar, as they did in 2010.

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A derivative instrument will lose its value if a commodity price falls below locked-in levels, but the company should be able to offset that loss by buying it for the lower price in the open market, notes Haslett.

“If something is truly a hedge, what you’re out to do is take a financial position in one security with the hope that that would exactly offset a countervailing move” in another commodity or financial position, says Robert Hoyt, professor of risk management and insurance at the University of Georgia.

Hoyt, citing corporate concerns over global financial markets, says he now sees more companies hesitating to use derivatives and opting instead for other ways to manage risk, such as adjusting operations or sitting on cash.

Hedges, nonetheless, remain widely used.

Krispy Kreme, in its most recent quarterly filing, noted its exposure to fluctuations in flour, sugar, and shortening prices, and for the gasoline used in its delivery trucks. To bring greater stability to ingredient and fuel costs, the company said it purchases exchange-traded futures contracts for agricultural products and gasoline, and optionson such commodity contracts.

Gains and losses on the contracts are intended to offset losses and gains on the hedged transactions in an effort to reduce earnings volatility, said Krispy Kreme, which for the first half of the year reported a loss on agricultural derivatives and an unrealized loss on its cash-flow hedge. The company declined to comment for this story.

While derivatives accounting is complex, there are generally two ways companies can classify the instruments, according to John Parsons, a senior lecturer in applied economics at MIT’s Sloan School of Management and co-author of “Betting the Business,” a blog on financial risk-management for non-financial companies. The method chosen determines how the transactions appear on a company’s financial statement.

Quick Change for Business - A CNBC Special Report
Quick Change for Business - A CNBC Special Report

With hedge accounting, a derivative and underlying transaction can be accounted for together, so that if a company, for example, has a gain because soybean oil prices decline, the offsetting loss in the derivative should result in a net zero gain or loss if the transaction works as intended.

Risks & Critics

With non-hedge, or “fair value,” accounting, derivatives and underlying assets are recorded separately. If the price declines, the company will declare the derivatives loss on the books. Any offsetting gain from the cost of buying lower-priced goods may not be recognized for a few months, and won’t necessarily be itemized in the financial statement, although the result is essentially the same, Parsons said.

Risks and Critics

Risks associated with derivatives range from multibillion-dollar rogue-trading scandals to comparatively mundane but costly mismatches between the hedge and the underlying transaction.

“Companies may not be hedging, they may be speculating,” says MIT’s Parsons. “There are companies who will have those gains and losses on derivatives because they’re basically taking bets.”

Warren Buffett nearly a decade ago referred to derivatives as “time bombs” fraught with risk of human error and mischief. Indeed, the trading of complex derivatives was blamed for the 2008 global financial crisis, prompting enactment last year of the sweeping Dodd-Frank Act, which seeks to impose new regulations covering derivatives transactions.

Even as those regulations are being written—and resisted by the financial-services industry— UBS recently revealed that it had suffered some $2.3 billion in losses from a trader’s allegedly unauthorized derivatives deals, leading the Swiss bank’s CEO to resign.

Parsons believes even non-financial companies could face exposure to the actions of an in-house rogue trader. Derivatives, though, come with less scandalous risks, as well.

A significant problem is “basis risk,” a potential mismatch between the hedge and the risk being hedged, such that they don't offset each other perfectly. This can happen, for example, when commodities are related but not identical, or are produced in different regions and affected by local conditions.

Over the past couple of years, Parsons notes, basis risk has posed a problem for airlines that lost money on deals using crude oil futures to hedge their jet fuel purchases.

“Basis risk is a big problem in hedging. Because of basis risk you hedge less than the ideal,” Parsons says.

Quick Change for Business - A CNBC Special Report
Quick Change for Business - A CNBC Special Report

In some cases, a hedge may simply prevent a company from making a bigger profit.

“Hedging is very important, but it’s kind of like a double-edged sword,” says the CFA Institute’s Haslett. If a gold producer decided to lock in its sale price at $700 an ounce and the metal rose to $1,500, the company would forgo the benefit of that increase, he noted.

Haslett recounted a presentation years ago from a gold-mining company CEO who said his company did not hedge. “They feel their shareholders buy their company to get an exposure to gold, and if they were hedging their gold product they would be limiting their profit potential should gold rise,” he said.

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