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Essay topic: why companies use currency derivatives?Currency derivative can be defined as a contract or financial agreement to exchange two currencies at a given rate or a contract whose value is derived from the rate of exchange of two currencies on spot (Shoup, 1998). Currency derivatives are developed and adopted to implement a strategy known as hedging, in which an organisation acquires a contract in order to offset an expected drop or rise in value of a position or future cash flow (Belk & Edelshain, 1997). This essay will outline the incentives and rationales behind an organisation that uses currency derivatives.There are three types of currency derivatives used in hedging, future contracts, forward contracts and options, although swaps are also commonly considered as a currency derivative (Shoup, 2008). These instruments are derived from a spot rate, which is the price of the ―underlying currency‖ (Eiteman, Stonehill & Moffett, 2009). Options are normally more costly than future contracts and forward contracts, because options are rights rather than obligations to buy or sell a currency (gives buyers the right not to exercise the contract if the spot rate movement is not favourable) (Belk & Edelshain, 1997). Research in New Zealand indicates that 70% of currency derivative users used forwards, which are most prevalent currency derivative instrument (Chan, Gan & McGraw, 2003). This is possibly because forwards are easy to manage and understand and can be used in frequent and uncertain transactions. Over-the-counter options are the second most popular instrument by NZ users of currency derivatives (40%), as options give users more flexibility (selling or buying a currency only when the firm can earn profit) (Chan et al, 2003).There are basically two purposes currency derivatives serve when they are used. The first is to speculate on the favourable currency movement and earn profit from currency fluctuation (Eiteman et al, 2009). This normally requires users to have profound knowledge of currency movements and accurate expectation. However, the benefit is that participants can earn profits. A good example is that international investors are scheduled to create a dairy product derivative in NewZealand in June. Although not qualified as a currency derivative in technical terms, this derivative bears resemblance to currency derivatives essentially (Rutherford, 2010). For example, if a buyer believes that the future rate is lower than the spot rate at a given date, he/she can enter a future contract to buy a dairy product at that date and then sell it immediately in the spot market therefore earning the differentials. The currency derivative operates in the same principle.In a study of the US’s fortune 500 firms, Geczy, Minton & Schrand (1997) found that hedging is used by organisations normally for risk minimisation rather than speculation. A potential explanation is that it is a complex job to predict currency movements; the expense of analysing currency movements which cannot be justified by income (Maurer & Valiani, 2007). Let alone, exposure to currency risk can be compounded by economic exposure. Organisations are more likely to perceive currency fluctuation as a threat rather than an opportunity. This accounts for the fact that when an organisation suspects that a financial distress is imminent, it is very likely to use a currency derivative while this threat is remote, it will not use a currency derivative (Hagelin, 2003). In New Zealand, Air NZ is a successful firm which has used foreign exchange derivative. As an organisation whose income is heavily exposed to exchange rate changes, Air NZ has enriched experience in the use of hedging. In 2009, the organisation earned a total of $ 272 million dollars from hedging, compared to its total net profit of $ 118 million (McNabb, 2009). Although Air NZ claimed that the hedging is not in speculative nature, it is clear that the organisation’s successful prediction over the appreciation of New Zealand dollars allowed it to profit from boosting income at a relatively low forward contract rate (compared to the spot rate).The second is to combat the unfavourable currency movement by reducing the negative impact of currency exposure (Eiteman et al, 2009). This can be understood by the fact that for an organisation who is involved in international business, exposure to currency fluctuation accounts for the dramatic variance of the organisation’s income and expenses(Cusatis & Thomas, 2005). It is found that forward contracts are normally used to eliminate the variance involved incontractual commitments while option-type contracts are used to reduce the impact caused by uncertain foreign currency denominated future cash flows (Bodnar & Gebhardt, 1999). As in most cases, payment and experiences are contractual obligations, forward contracts are more popular, but for big organisations who have a bigger number of uncertain payments received from overseas customers, options can be also commonly seen (Bodnar & Gebhardt, 1999). In general, an organisation that has a higher level of foreign pretax income is more likely to benefit from hedging in this case (Geczy, et al, 1997).A good example to illustrate this is that assuming Fonterra is to receive a payment from a US customer due in six months, Fonterra might enter a forward contract with the speculation that the NZ dollars will be appreciated during this period (leading to a lower income when the USD-dominated payment is converted into NZ dollars). In this situation, a forward contract, which might allow Fonterra to sell USDs at a higher USD/NZD rate, Fonterra can thus gain protection from a potential loss to its income. This example is simple and hypothetical, but sufficient to illustrate how an organisation can reduce transaction exposure by using currency derivatives. In 2010, Fonterra owes its financial performance to the positive hedging gains despite the appreciation of New Zealand dollars (Andrea, 2010).A close control over cash flows also has other implications. Geczy, et al (1997) argue that it affects an organisation’s pricing strategies. For medium enterprises, which normally cannot afford to sustain their products’ prices in an offshore market for a protracted period of time (regardless of dramatic currency fluctuation), currency derivatives enable them to fix the cost of its operation at a specific date in future, thereby making it easier to price its products (Hill, 2006). That’s perhaps the main reason why Geczy, et al (1997) found that firms in the consumer goods industry are more likely to use currency derivatives than other industries, as these firms are sensitive to any change in the price, which can have a heavy impact on their bottom line. Years ago, Air NZ used hedging to fix the fuel it purchased from its global suppliers and therefore protected itself fromthe surge in the fuel price, which occurred between 2006 and 2008 (Eiteman et al, 2009).In New Zealand, many organisations such as KiwiBank and Telecom have debts denominated at foreign currencies. If New Zealand dollars are depreciated substantially, these organisations would be at risk of financial losses or even bankruptcy. Derivatives such as futures and forwards provide considerable certainty and predictabi lity over an organisation’s cash flow so the organisation as well as its stakeholders has a clear picture of the organisation’s balance sheet in future (DeMaskey, 1995). That’s why Geczy, et al (1997) observe that an organisation that has a higher long-term debt ratio is more likely to use derivatives. It is also applicable when organisations have accounts payable due in overseas markets (such as importers), forward contracts or future contracts can minimise the negative impact if the home currency is depreciated (McNabb, 2009).In view of these functions performed by currency derivatives, both management and shareholders are in favour of this tactic. Managers’ remuneration is normally associate d with the organisation’s financial performance. As currency derivatives are normally considered as tactics preferred by risk-averse managers, shareholders appreciate these managers, especially in turbulent times and due to the lesson learned from the credit crisis (Livingstone & Grossman, 2002). This is particularly true in cases where managers have a big ownership share of the organisation (Hagelin, 2003).Shareholders, who have also become increasingly risk averse, are interested in stability of the return on their investment, instead of a dramatic variance. Currency derivatives contribute to certainty about minimum equity and also a stable debt-to-equity ratio (Livingstone & Grossman, 2002).For shareholders, hedging is primarily dealing with translation exposure (or accounting exposure), reducing the impact of currency movements on an organisation’s balance sheet when the overseas income is converted in the currency of the home country at the end of the financial year (Bodnar & Gebhardt, 1999). A latest example is thatFisher & Paykel healthcare managed to stabilise its pretax profit in the US market at $ 20 million, despite the relative strength of NZDs in the year to June, 2010 (Adams, 2010).The cost of using currency derivatives can be a deterrent to organisations, but studies give contrasting conclusions about the relationship between firm size and the use of currency derivatives. Hagelin (2003) found that a smaller firm is more likely than a bigger firm to use currency derivatives (despite the cost), perhaps because smaller firms have limited resources to exercise different options in management. For example, if the currency fluctuation multiplies the debt burden of the organisation, a small firm finds it more difficult to raise fresh money from external funding sources than a big firm does (Hagelin, 2003). As a result, a small firm is more risk-averse than a big firm. Geczy, et al (1997) however found that bigger companies are more likely to use currency derivatives because they have experience in using various currency derivatives and can afford such instruments.In New Zealand, where small businesses account for a majority of registered companies, the use of currency derivatives is limited, due in large part to the lack of knowledge in this aspect. The cost incurred by currency derivatives is also an important concern. Bodnar & Gebhardt (1999) discover that it is difficult for managers to convince shareholders that it is reasonable to use currency derivatives when hedging against translation exposure, because shareholders are concerned about the cost involved. Shareholders are comfortable with hedging against transaction exposure. In addition, many companies use other tactics other than currency derivatives to reduce the impact of currency fluctuation on their operation. For example, many wine exporters sell products in various markets around the world, thereby reducing the impact of a specific currency on their income (Harris, 2010).In conclusion, companies use currency derivatives basically for two reasons, speculation or risk minimisation, in response to the fluctuation in the spot market, either favourable or unfavourable to their operation and bottom line. Studiesintend to show that risk minimisation is the predominant purpose. There are different elements companies consider when selecting a currency derivative. The cost of a currency derivative, the macroeconomic environment (whether there is an imminent financial distress), the risk the organisation is willing to take, the nature of the transaction (account payable or receivable), the types of exposure to deal with (transaction exposure or translation exposure) and so forth are among those commonly considered elements. Studies show that organisations use forward contracts more than options in hedging, primarily because forward contracts are less expensive and easier to manage, especially when payment and income are committed. Organisations such as Air NZ and Fonterra have gained considerable benefits from currency hedging, but for other organisations, which are relatively smaller in size, how to use currency derivatives effectively is still an issue of concern.ReferencesAdams, C. (2010).F&P Healthcare to gain from US reforms. 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