¶ … derivatives in general and discusses their use by Rolls-Royce plc in its risk management programme.
Derivatives derive their value from an underlying financial instrument and as such, they allow a way of accessing and trading in the value of the underlying instrument without needing to put up the full value of that underlying instrument. Derivatives can be used for a number of purposes, including leverage, hedging, income generation and profiting from long and short positions (Wise Owl, n.d.).
Companies like Rolls-Royce use derivatives for hedging risk, allowing them a form of insurance. Typically companies use derivatives as a tool within a risk management program. Recent research shows that more than 90% of large U.S. companies use derivatives regularly (Brigham and Houston, 2009, p. 581). Hedging allows managers to focus on running their core businesses without needing to worry about variability in interest rates, currency, and commodity prices.
Rolls-Royce uses hedging for these purposes. According to the company's 2011 annual report, Rolls-Royce used various financial instruments in its efforts to manage exposure to movements in foreign exchange rates. The company used commodity swaps to manage its exposure to movements in the price of jet fuel and base metals. To hedge the currency risk associated with a borrowing denominated in U.S. dollars, the company used currency derivatives. To manage its exposure to movements in interest rates, the company used interest rate swaps, forward rate agreements and interest rate caps (Rolls Royce, 2012).
Companies may pursue other risk management alternatives as well. Once the decision has been made to manage a given risk exposure, the manager must evaluate the effectiveness of various risk management alternatives by analyzing the associated risks, along with the costs and benefits of each. Generally speaking, there are two main alternative risk management categories to consider in addition to derivatives, policy decisions and cash market transactions.
Policy decisions include those business policy decisions that a company's management makes as part of their on-going effort to reach their competitive position and financial performance objectives. Policy decisions tend to be the least costly to put into place, but they also tend to be somewhat limited in their usefulness for managing all the exposure to be managed without eliminating the potential for profit. Even so, this alternative should be exhausted before moving to derivatives (Strategies and Tactics, 2006).
The other risk management alternative, cash management transactions, includes conventional transactions that a company's management uses to manage the company's balance sheet in conformance with regulatory guidelines and industry practices. In the case of financial institutions, these transactions are typically money market, fixed income, mortgage backed, and equity securities related transactions. It is best to use these alternatives when there is still exposure remaining to be managed after policy decision alternatives have been exhausted but before using derivatives. Derivatives, the remaining risk management alternative, tend to have more inherent risks, and should be used only when there is risk remaining to be managed after policy decision and cash market transaction alternatives have been exhausted (Strategies and Tactics, 2006).
Even though a company's management may make a conscious decision to manage a given amount of risk exposure and may pursue exhausting all policy decision and cash market transaction alternatives, it is possible that some exposure may still remain to be managed. When this happens, managers must focus on evaluating the risk/reward profile associated with using derivatives to manage the remaining exposure. This evaluation occasionally will show that the risks associated with using a derivatives-based strategy may actually exceed the benefits of attempting to manage the remaining unmanaged exposure. Consequently, in some instances there is no practical alternative to managers other than continuing to accept the unmanaged risk exposure (Strategies and Tactics, 2006).
To be effective, derivatives must be used as part of a strategy. How well a derivative strategy works will depend upon the use to which it is applied, hedging or speculating. According to most analysts, hedging is considered to be good while speculating in an effort to increase profits is considered to be bad. While hedging is accepted business practice, it is expected that firms use it primarily to manage exposure to risk.
Given the benefits of hedging, sophisticated investors and analysts demand that firms use derivatives to hedge certain risks. One such example happened with Prudential Securities reducing its earnings estimates for Cone Mills, a North Carolina textile company, because Cone did not sufficiently hedge its exposure to changing cotton prices. Any company that can safely and inexpensively hedge its risks is expected to do so (Brigham and Houston, 2009). In scenario, hedging or...
Thus, the company is not attempting to either "win" or "lose" with its transactions. Thus, either may occur over any given period. An example of a fuel hedging "loss" occurred in late 2008 and into 2009. During this period of high volatility, fuel prices shot up as high as $140 per barrel in mid-2008, only to quickly crash down to $40. This volatility is a tremendously challenging environment. The
Derivatives in Risk Management One of the uses for derivative products is in risk management. Organizations have recognized that derivatives can be used to manage risk by offering guaranteed outcomes for a set up-front cost. For firms that face risk due to fluctuations in asset prices -- typically commodities or currencies -- beyond their control, derivatives represent a means of achieving cash flow certainty, if not profit certainty. This paper will
DeMarzo and Duffie, (1995), also argue that the presence of hedging may be utilized by shareholders as a way of interpreting the quality of management, with hedging generally deemed to be a beneficial strategy. The perceived lower risk profile may also aid in other areas, such as increasing the ease with which capital raising may take place. It is also speculated that large organizations may be able to benefit from
While the first chapter was brief, it is important to explain what will be studied and then move forward into the literature review. In Chapter 2, the literature review provides a review of academic literature by way of journals and textbooks. This information is placed into separate sections which allow for ease of understanding. An introduction is made to capital structure, and information is given on the Indian capital structure
Ford Motor Company Over the last several years, Ford Motor Company has been through a tremendous amount of challenges. This is because they were adversely impacted by the financial crisis and consumers switching to fuel efficient vehicles. Despite these issues, the firm has continued to adapt and become stronger. However, there are renewed worries that a secondary slowdown in consumer spending could adversely impact the automaker. To fully understand what is
"Management believes that the accounting estimates employed are appropriate and the resulting balances are reasonable; however, due to the inherent uncertainties in making estimates actual results could differ from the original estimates, requiring adjustments to these balances in future periods." Based on the data retrieved and the projections made, the accounting division will proceed to the development of the consolidated statements for all of GM subsidies and the overall group.
Our semester plans gives you unlimited, unrestricted access to our entire library of resources —writing tools, guides, example essays, tutorials, class notes, and more.
Get Started Now