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Managing Risk Through Contracts

June 20, 2009

The Economist reveals interesting insights to the world of derivatives and their use in corporate risk management (Corporate Hedging Gets Harder, June 18th 2009). It also highlights that this important mechansim may be under threat, a victim of the credit crunch and the readiness of banks to carry risk. This could have significant impact on the riskiness of doing business with key suppliers and customers.

The article explains how many firms use derivatives to protect themselves against the swings in commodity prices. For example, as many as 55% of the world’s large companies last year hedged their exposure to fuel prices – and in many cases they now face large paper losses because the price fell so far and so fast. According to the article, “Among the hardest hit have been airlines, many of which paid to protect themselves from higher fuel prices last year when the oil price peaked at $147 a barrel. Because oil now costs much less, many have had to write down the value of those contracts, even if they are not due to be settled for years. The losers included Cathay Pacific Airways, which made paper losses of close to $1 billion, Ryanair, Air France-KLM and Southwest.”

38% of large companies also use derivatives to protect themselves against currency movements and interest rate hikes. The volume and value of such contracts has grown steadily in recent years, up by about a third last year alone.

So it is through this world of finance that many companies are protecting their ability to trade profitably and to manage the uncertainties of global markets. And apparently their bankers smile on those who hedge their risks in this way – it has a direct effect on the banks willingness to lend and thereby provide working or investment capital.

However, the credit crunch has reduced the appetite of banks for carrying risk, so only companies with the highest credit ratings can now obtain derivative contracts. And according to the Association of Corporate Treasurers, “some perfectly solvent banks have wriggled out of derivative contracts by invoking obscure break clauses that they had previously promised their customers they would never use”.  

Even for those who can obtain bank support, the associated bank fees have risen dramatically – from a typical rate of 0.1% of the contracts to levels as high as 2%. Those whose credit rating has dropped face a different problem. Fearing that some of their cash-strapped customers may default, banks “are asking firms to post collateral for the money they owe on derivative contracts”.

This specialist area of risk management has been of major importance in supporting the growth of world trade and the management of key aspects of supply chain risk. The additional costs and limited availability of such instruments has created a new set of risks about which most business-to-business negotiators are only dimly aware. As we look at selection criteria for suppliers or customers, we may increasingly need to understand the extent of their exposure to commodity price or currency fluctuations – and seek assurances over the quality of their hedging of such risks.

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