Derivatives Use by Issuers

Corporate users of derivative instruments are considered issuers of derivatives. A non-financial corporation may have risks associated with changes in asset and liability values as well as earnings volatility from changes in various underlying securities or interest rates. Some examples are:

• A corporation may have income in a foreign currency and hedge the exchange rate risk with forwards to smooth earnings reported in their domestic currency.
• A corporation may use fair value reporting for its fixed-rate debt, and that value changes as interest rates change. By entering an interest rate swap as the floating-rate payer, the corporation has essentially converted the fixed-rate liability to a floating-rate liability that has much lower duration so that its balance sheet value is less sensitive to changes in interest rates.
• A corporation with a commodity-like product may carry its inventory at fair market value, leading to fluctuations in the value reported on the balance sheet over time as the market price of their product changes. By selling forward contracts on an underlying that matches well with their product, the firm will have gains or losses on the forwards that offset decreases or increases in reported inventory value. With the market value of the forward position also reported on the balance sheet, total assets will have less variation from changes in the market price of their product.

Accounting rules may permit hedge accounting. Hedge accounting allows firms to recognize the gains and losses of qualifying derivative hedges at the same time they recognize the corresponding changes in the values of assets or liabilities being hedged. Issuer hedges against the effects of a changing price or value of a derivative’s underlying are classified by their purpose.

• A hedge of the domestic currency value of future receipts in a foreign currency using forwards is termed a cash flow hedge. A swap that converts a floating-rate liability to a fixed-rate liability is also considered a cash flow hedge (cash flows for interest payments are more certain).
• A fair value hedge is one that reduces (offsets) changes in the values of the firm’s assets or liabilities. Our examples of a firm that uses derivatives to hedge against changes in the balance sheet value of its inventory, and a firm that uses an interest rate swap to decrease the volatility of debt values on its balance sheet, are considered fair value hedges.
• A net investment hedge is one that reduces the volatility of the value of the equity of a company’s foreign subsidiary reported on its balance sheet. Foreign currency forwards or futures can be used to hedge changes in the reported value of the subsidiary’s equity due to changes in exchange rates.