Warren Buffet called derivatives “financial weapons of mass destruction”. Warren is right, as always, but he also understands their purpose. Derivatives can be extremely risky investments, but when used properly, they are tools to reduce risk. It is very important when implementing a hedging strategy to build in sufficient oversight & accountability and follow the policy closely. This not only protects the interests of the company, for the CFO it is about CYA – covering your ass-ets. When done right, a hedge strategy is like insurance. It costs the company money and you hope you never need to use it. It’s about cutting your losses, not making money. The idea is the cost of the hedge is far less than the potential loss had you not hedged. CEO’s and owners will sometimes forget this point and question why you spent money on derivatives that expired with no value. If the strategy was clearly presented to them, they participated in the decision and signed off on it, it will help them remember the blurry uncertainty you were hedging against at the time the strategy was implemented, which can be difficult to see when hindsight is 20-20.
To help you evaluate a company’s use of derivatives for hedging risk, in this 3 part series, we’ll look at the three most common ways to use derivatives for hedging.