What is a Derivative?

 

A derivative is a financial instrument whose value is tied to a separate, underlying asset (like a commodity) or benchmark (like an interest or exchange rate) that many non-financial companies use to manage day-to-day business risk by swapping a floating price or rate for a fixed price or rate with a counterparty.  Companies are willing to pay a premium for the certainty this transaction provides because it reduces their exposure to fluctuations in the value or price of the underlying asset or rate.  While some derivatives (futures, for example) are traded on exchanges, Over-the-Counter (OTC) derivatives are private contracts negotiated between counterparties.

Over-the-Counter (OTC) Derivatives are private derivatives contracts negotiated between counterparties that allow a company to customize the derivative to precisely match its risk.  By contrast, exchange-traded derivatives are guaranteed by third-party clearinghouses, and are purchased “off the shelf” so a company’s choices are limited and may or may not completely hedge the underlying risk. 

 

 

 

How Honeywell Uses Derivatives

 

“The purpose of our hedging activities is to eliminate risks that we cannot control, allowing us to focus on our core strengths, namely delivering high-quality products, on time, to our customers in a manner that not only meets, but exceeds expectations.”

Jim Colby, Assistant Treasurer, Honeywell International, explained in testimony before the House Committee Agriculture hearing to discuss bipartisan legislation—including H.R. 634 and 677— that will prevent end-users from having to make a choice between growing their business and hedging their risk and explained the importance of these exemptions for Honeywell.  

Honeywell uses derivatives to protect themselves from exchange rate fluctuations. They sell components for satellites that are manufactured in the U.S. to customers in Germany and are often required to enter into multiyear contracts denominated in Euros, although the production costs are in U.S. dollars. Over the life of the contract exchange rates between the Euro and the U.S. dollar can significantly impact the economic stability of the project. 

How FMC Corp Uses Derivatives

 

“We are offsetting risks—not creating new ones.”

Tom Deas, Vice President & Treasurer, FMC Corporation explained in testimony before the Senate Banking Committee.

FMC is the world’s largest producer of natural soda ash, the principal input in glass manufacturing, and is one of the largest employers in the state of Wyoming. We can mine and refine soda ash products in southwestern Wyoming, ship them to South Asia, and deliver them at a lower cost and with higher quality than competing Chinese producers.

Energy is a significant cost element in producing soda ash and FMC protects against unpredictable fluctuations in future energy costs with OTC derivatives to hedge natural gas prices. These derivatives are done with several banks, all of which are also supporting FMC through their provision of almost $1 billion of credit. Our banks do not require FMC to post cash margin to secure mark‐to‐market fluctuations in the value of derivatives, but instead price the overall transaction to take this risk into account. This structure gives us certainty so that we never have to post cash margin while the derivative is outstanding. However, if we are required by the regulators to post margin, we will have to hold aside cash and readily available credit to meet those margin calls. Depending on the extent of price movements, margin might have to be posted within the trading day as well as at the close of trading. Because failure to meet a margin call would be like bouncing a check, and would constitute a default, our corporate treasury would act very conservatively in holding cash or immediately available funds under our bank lines of credit to assure we could meet any future margin call in a timely fashion and with a comfortable cushion.