DERIVATIVES

Title – Impact of Derivatives on the Non-Financial firms in UK

Introduction

As per different theories and the nature of nonfinancial corporations it is evident that the firms
are exposed to high risk. In this scenario, the use of derivatives is evident as it lowers the
financial distress costs, leads to coordination of the cash flow with the investment, resolves the
conflicts of agency between the managers, as well as owners. The influence of the derivatives are
not only linked to traditional usage but even linked to other financial and operating decision
making that are not directly linked. The usage of derivatives helps in the maturity ascertainment
of the debt, construction of the policy of dividend, liquid assets in possession and hedging of
international stature. In the recent past, there have been several trends in the financial market
such as globalization, technological advancement, and an innovation that has played a pivotal
part in the financial sector (Bartram, 2006). In tune with this, re-evaluation of the risk and capital
management has assumed a place of special importance.

The decision to utilize financial derivatives for the purpose of hedging comprises of the
comparison between the costs and the benefit. The benefit mainly resides in the mitigation of
volatility in the cash flow of the firm or in the market value of the assets or liabilities that may
have an adverse impact on the investment plan (Aabo, 2007). Hedging in terms of Cash flow
reduces the chances that the firm might face with costly external financing for the investment
projects due to shortfalls in cash. Other benefits from hedging come in the form of higher firm
valuation that is attributed to the feature of the tax code and that helps in lowering the financial
distress cost.

In the past two decades, there have been numerous studies that have evaluated the practices of
risk management undertaken by non-financial companies. Some studies shed light on the
utilization of derivatives by the non-financial firms in the UK while others shed light on the
process of corporate hedging (Lee-Lee, C., Xiao-Jun, C., & Siow-Hooi Tan, 2014). As corporate
risk management is an essential consideration of the business strategy hence, the major goal of
the companies should be to ward off the risk (Bartram, 2006). The factor that supports the usage
of the derivatives lies in the liquidity, size and the leverage of the company. For instance, the

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hedging of cash flow enables the firms to keep the oppression of external financing at bay by
establishing the cash flow as per the need of the investments.

Literature Review

Why do firms hedge?

Corporate hedging can be defined as a manner in which the corporation can safeguard itself from
the foreign exchange rates. In short, it is a mechanism to safeguard from the exposure of foreign
risk. This process is maintained by the firm treasury officials and they put efforts for the
maximization of the foreign income and minimization of the costs. The companies tend to hedge
for the main reason of foreign currency fluctuations as risks are strongly connected to the central
business operations (Bartram, Brown & Fehle, 2009). Hedging is undertaken to avert the rise and
fall in the market irregularly from the interference with the business dealings in terms of
investments, costs, and financial distress. Currency matching reduces the chances of financial
distress and allows the firm to ensure more stability in the process of earnings and higher
leverage. Hedging can be possible if exposure is well known at the initial point of time to define
and ascertain the exposure, and it must be clear regarding the effectiveness of instruments like
forwards, swaps, options, etc. The act of exposure covering is done to help in the reduction of the
firm volatility that lessens the firm volatility (Bartram, Brown & Fehle, 2009). Exposure
management is a mechanism that helps in reducing the firm’s variability of the firm profit or
valuation caused by the alterations in the rate of interest and exchange rate. The non-financial
companies develop, as well as implement risk and management plans of capital that help in the
creation of shareholder wealth. Not only, it helps in adhering to the shareholder demand but it
also helps in the finance function.

Hedging tends to enhance the shareholder’s value by reduction of the capital cost and income
earned is more stable. The prime aim of any hedging policy is the attainment of the
organization's optimal risk profile that helps in the computation of the advantages of protection
against the hedging cost (Toerien & Lambrechts, 2016). A policy of hedging that is well
designed and suited to the organizational objectives helps in the reduction of costs and risks. It

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tends to free the resources and steer the management to take into account the investment that can
reap better results by a reduction in the exposure that is not vital to the business.

 Some of the pivotal reason for the firm to hedge risks is as follows:

 Firm that is risk hedgers can derive the benefits from tax laws

 Reduction in risk exposure helps the firm to utilize its capital structure in a better fashion

 Investors can derive complete information from the financial statements in terms of
relevant or irrelevant hedging and this projects meaningful information

 Hedging against risk is a common phenomenon, however, the presence of exchange rate
risk and commodity price seems to be the most widely used

A firm is encountered by different situations like interest rate, exchange rate or commodity price
risk can be defined as a vital condition for the firm to have control over the risk. The most
effective condition is that exposure management enhances the firm’s value. It can be defined in
the following manner:
E (NCF) = Expected Net Future Cash Flows, V can be defined as the firm's value and K is the
cost of capital.
If the value of the firm is to increase then it should be done in terms of increment in the expected
net cash flow or decline in the rate of discount. The hedging of the risks is done by way of
appropriate management policy that sheds light on expsoure, currency risk, interest rate risk and
commodity price risk and the interpretation of the same can be done by dint of relevant portfolio
theory. The active management of such risk should comprise of no influence on the cost of
capital of the firm. The expected value of the firm should in no case be enhanced by the process
of risk management by decline in the rate of discount (Nguyen, 2018). Exposure management is
expected to enhance the firm’s value by an addition to the net cash flow that is forecasted and is
well maintained by the diversified investors.
Hedging tends to reduce the financial distress and in this scenario, the shareholders will be
demotivated to have excess equity for the financial resources and hence a chunk of the gain will
be provided to the supplier. By declining the volatility of the future cash flow, the utilization of

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the hedging strategy will lead to a decline or complete removal of the financial distress and
enhance the worth (Dhanani, Fifield, Helliar & Stevensen, 2008). The borrowing capacity is
enhanced by hedging when the company’s value volatility is lessened. More suppliers will be
ready to provide loans to the organization because additional loan financing will lead to value
generation only if it means to fund the project with a positive NPV, hedging enhances the
company’s capacity due to management risk efficiency.
Hedging leads to a forecast of risk aversion (Carlton, 1999). An Increment in the organization's
volatility impacts the ability of the organization to conduct business in the usual manner in
different perspectives like business loans, retention of an employee, customer satisfaction, etc.
Hence, managers look forward to the process of risk aversion by utilizing hedging for the
reduction of volatility (Paton, 2006).
 
 Theory of Modigliani and Miller
As per Proposition 1, the firm’s value is ascertained by the cash flow from assets and not related
to the capital structure. The proposition is showcased to project the irrelevance of the selection
between debt and equity. The proposition is applicable to the set of contracts utilized to finance
the firm. Such consists of hedges as hedges are implemented with financial contracts that
influence the firm’s balance sheet. Hence, it is stated that the M-M Proposition of Hedging is an
impact of the original M-M Proposition 1.
.
 Value creation in respect to imperfections in the capital market
 Managers are influenced by the concept of value maximization
 Easy to tame the market movements

Even corporate governance supports the fact that the utilization of hedging is highly influenced
when it comes to corporate environments where the managers are influenced to act in a manner
that will help the organization to enhance the value. The manager of the organization with weak
governance consists of more discretion and utilizes the derivatives for managerial, as well as
speculative purpose however, managers with strong governance policies use derivatives to
manage risks (Campbell, Mauler & Pierce, 2019). Even managers can use the derivatives to tame

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the movements in the market that will helps in increasing the corporate risk exposure to earn
more profits and lessen the volatility of the firm.
 
Article 1 - (page 3-5) Derivative Practices in Australian and Canadian Industries) 
Differentiation of Australian and Canada techniques with the UK companies
Non-financial companies is more inclined to risks that are not easy to be hedged. Even, the
nature of the risks remains such that risk management is broken as compared to the financial
institutions. This will partially endorse a reason why non-financial companies are often defined
by various plans in contrast to financial institutions. The potential movement in the non financial
companies’ leads gives a prompt reply why does it have strategies in action.
A chief feature non-financial company is that the financial exposure happening from powerful
movement in the market prices like exchange rates, interest rates, and commodity prices cannot
be segregated from the business that is underlying. The factors that bring changes to the cash
flows are variables of complex and financial that is interlinked with the cash flow produced by
the business. Hence, the decision in terms of exposure to hedge or not to hedge is complex.
For instance, the indirect economic exposure of a local operating non-financial company can be
cited in this scenario. A company that is operating specifically in the local market and involved
in completion with the importers will have a stronger exposure in terms of exchange rate as an
export company. A stronger AUD will indicate that the imports are cheaper and will put
additional burden on either pricing or market of the supplier who function.
However, one issue that needs to be answered by the importing companies is the need to know
the currency that is effective for the commodity. Though there are different commodities in
terms of USD, the effective currency will reside on the link between the marginal supply and
demand, products that are substitute, etc (Wolf, Boulter & Bhattacharya, 2017).
Figure 1 provides a simple coverage of the corporate happening and strives to provide an
explanation of how risk management function within the higher plans of the organization. The
main aim of value maximization is attained through the performance, investment and other
financial aims of the firm.

Performance, Investment & Financial Strategies of Non-financial companies

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Non-Financial firms in UK

Contrary to the financial institutions, business plans in non-financial companies like product
diversification and location, are an element of the function of risk management. It is imperative
to consider the real or operational response that is present for non-financial companies in terms
of management of risk. On the other hand, operating leverage is another way to respond to the
volatile market, alterations can be done in respect to production volumes to anticipate changes in
the prices of the markets, alterations to the portfolio through the project screening can be done
and diversification in tune to the portfolio can be done for absorption of risk. 
Similar practice has been observed in the case of Vodafone that is a pioneer in the
telecommunication industry, with the growing trend in the telecommunication industry, the
company is exposed to variety of financial risk most importantly in foreign exchange and interest
rate risk. The risk if left will create immense issue for the companies. Hence, not only in case of
Australia or Canada but the hedging case is observed in different countries as seen from the
concept of Vodafone.
Article 2 - Derivatives Usage in Risk Management by US and German Non-Financial
Firms: A Comparative Survey (pg167-169)
Derivative usage in Foreign Exchange Risk Management
German firms have a tendency to utilize more derivatives as compared to US firms, with 78% of
the German firms utilizing derivatives in comparison to 57% of the US firms. With the total

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usage, the manner of usage across industry and stature grouping is compared across two different
countries. In both countries, it can be seen that foreign currency derivative is commonly used
which is followed by interest rate derivative with commodity derivative utilization ranking the
third. The utilization of all three components of derivatives is more for firms of German as
compared to US firms. By the study, it can be commented that the utilization of all classes of
derivatives is more for the German firms in contrast to the US firms (Bodnar & Gebhardt, 1999).
When it comes to similarity, firms in two different countries vary majorly in terms of issues like
the hedging goals, the instrument choice, and alterations in the market view while assuming a
position of derivative. The differences tend to be impacted by the greater utility of Germany
financial accounting statements as compared to the US and German corporate plans of control
over the activities of derivative within the firm. German firms indicate less concern in terms of
the derivative related issue as compared to the US firms that appear to derive from a basic and
simple plan for derivatives utilization. Finally, when it comes to derivative non-users, German
firm provides reasons that suggest derivatives were not required while US firms provide reasons
that suggest a possible role for derivatives but hesitate to use that for reasons. 
Foreign exchange exposure can be differentiated into three main types that are the transaction,
translation, and economic exposure and this can be commented as the main forms of foreign
exchange exposure in the case of non-financial firms. Foreign exchange exposure persists for a
non-financial firm when the overall value of the future cash flow is depending on the valuation
of the foreign currencies. 
Transaction exposure is associated with the actual currency transaction those are foreign.
Transaction exposure denotes the actual transaction that happens in a business involves foreign
currency. In business, every transaction that involves money is ultimately meant for profit.
Hence, there are chances that the final aim might be hampered if the currency transaction and the
market as a whole move in an adverse direction.
Translation exposure is mainly associated with accounting representation. It is because the
exposure takes place in the books of accounts into the home currency. The activities are carried
in terms of reporting. The financial statements that are translated denotes the actual position of
the company in terms of home currency.
The economic exposure is connected to the exposure at macro-level that might be genuine for the
entire industry instead of the non-financial firm under question. This exposure has a major

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impact on the non-financial firm valuation. It can have a direct influence on the assets and
operating cash flows. 
Article 3
On the optimal mix of corporate hedging instruments: linear versus nonlinear derivatives
(pg 219-220)
Substitution between linear versus nonlinear derivatives – impacted by the output and prices
correlation
When it comes to negative correlation, prices tend to be high or low when the realization of the
firm is low or high. It leads to a natural hedging impact and leads to a reduction in the overall
demand of the firm for hedging instruments. On the contrary, the negative correlation enhances
the chances that the firm will have the issue of over hedging.
Linear contracts – when risk of quantity reaches non-zero, the level of uncertainty in terms of
actual output level makes the avoidance of over hedging a complex task. Considering a situation
where the expected amount is projected at 10 units however due to quantity risk, the quantity can
change from 6 to 14 units. At a previous point of time, 8 forward were optimally needed. If the
firm proceeds with total number of 8 forward contract then over hedging can happen if the output
realization falls in the range of 6 and 8 units. To prevent over hedging, the firm needs to sell 6 or
less of forward contracts (Gay, Nam & Turac, 2003). However, if lower than 8 forward contracts
are sold then it exposes the firm to other cost of distress in the event if the price falls. Hence the
non-financial firm reaches somewhere 6 and 8 contracts. 
 
 
Article 4 - International Evidence on Financial Derivatives Usage (pg 185-187)
Examination of motives that influences the usage of financial derivatives
The financial planning of non-financial companies has been influenced both by momentum in
the financial market and the alteration in the corporate ambiance. The changes have been done
brought about by:
Regulatory environment change
Among various other processes of developments, the alterations have provided the usage of share
buy-backs and provided for heavier adaptability to the offshore market. 

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Non-Financial firms in UK

Globalization – Companies have now wider access to the international markets. This can provide
immense benefits; it even implies that companies are prone to financial markets changes and
competitive pressure. 
Disintermediation - the trend of disintermediation has undergone immense change and this has
led to change in the function of commercial banks, giving organization with complete access to
the investors. Further, the corporate lending process has undergone immense change,
transforming the manner in which the parties deal with the providers of banking (Haegn, 2003). 
Innovation – the new product development has led to an arrangement of risk transfer with some
tailored capital structure. 
Competitive structure – Rivalry among the financial bodies has opened the gates for
opportunities for end-customers so that adaptation can be made to some well defined techniques
that influence the process of innovation.
Technology – the changes in the sector of technology have led to the more efficient transfer of
payments. Even vital are the dramatic enhancements in technology like computing that have
given way for higher accurate predictions and derivatives pricing transactions.
The joint impact of the alterations in the financial markets has provided a new lease of life to the
different financial products. With the presence of different tools of hedging the financial
exposure has undergone immense change and this has led to better terms of the contracts
between the companies.
In the same manner, when it comes to the arena of capital management, deregulation in terms of
US and altering scenario in Australia have ensured the capital market more accessible in nature.
However, a wider scenario of credit features, coupled with the development of a variety of sets
of financial tools has led to the tailoring of capital structures.

Article 5 Does Centralization of FX Derivative Usage Impact Firm Value? (218, 221)
 Determinants of Firms value
 Does Decentralization influences Derivative Usage?
The agency cost of derivative happens when managers do not internalize the derivative cost
to shareholders like the cost of the transaction, managerial attention, or the increment in the
complexity of the firm projected in the financial statements. The process of managerial risk

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aversion can tend to more demand for derivatives as the shareholder of the firm will not like
hedging. A decentralized approach will come into practice with higher agency cost of
derivative utilization to the level that non-financial firms will face better incentives or
scrutiny of better form. Further, the usage of the derivative is evaluated by the BOD,
evaluaters and other stakeholders. Due to the process of a high level of direct engagement
with the disciplining forces, the non-financial firms will be required to internalize the
different cost of derivatives to an enhanced degree (Hakan, 2003). Further, it can even be
expected to internalize the various costs of derivatives to a greater degree. Even they can be
expected to internalize the cost relative to the higher level of ownership.
Article 6 why firms hedge with currency derivatives, an examination of transaction and
translation exposure (59-62)
Firms utilize derivatives so that hedging can be done to different kinds of risks. Hedging
exposure brings a lot of managerial, as well as financial resources. Thereby, it is important
from the shareholder perspective that whether the derivative hedging adds value. As per
theoretical research, various rationales are provided as to why the firms engage in hedging
practices. One of the major rationales is that hedging can increase the firm value by
reduction of the forecasted costs in terms of financial distress or lessening the problem linked
to underinvestment with external financing of costlier nature. Another opinion lies in the fact
that the private aims of poorly diversified managers that strive to lessen the exposure of risk
through the hedging activity of the firm.
The most prominent utilization of currency derivatives is to minimize the risk by offsetting
currency fluctuations through hedging (Judge, 2006). It can be used when producers ship
goods to other countries where it needs to be paid in other currencies. On the contrary,
arbitrage can be utilized when access to higher capital is witnessed. The differences in the
currency pair and exploitation of price can be done to make a profit from it. 
BHP Billiton that is a pioneer in the mining sector is exposed to exchange rate risk on
account of foreign currency sales and purchases. For instance, approximately 67 per cent of
the sales of the company were linked to US dollar. The majority of the operating cost of BHP
was denominated in US dollar. The most vital part of the risk is the forecasted US dollar
receipts of Australian based companies. The Group policy of BHP is to hedge to a maximum

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of 70 per cent of the rolling anticipation of Australian based entities in the initial and next
year and to a maximum of 50 per cent in the next three to five years.
Hence, it can be easily commented that whether a company is based in UK or Australia if it
is exposed to the fluctuations then it needs to hedge the risk with currency derivatives

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Conclusion
When it comes to the concept of risk management, it is well observed that the increment in
the risk level can be hedged and particularly for the non-financial companies. Better
utilization of the derivative products by the non-financial companies has ensured the risk
management tools and technique properly accessible. When it comes to the scenario of
capital management, the increment in the number and status of the required financial tools
has created complex capital and structure of ownership that are highly liked to the
requirement of the defined companies. The overall study sheds light on the financial
strategies of the companies of non-financial nature and such strategies denote the risk and
capital management. Further, reasons were cited considering the fact as to why the method is
linked to risk and capital management. Further, the assessment of the main financial plan by
the non financial firms is vividly described. The principles that underlie the shareholder value
concept and explain how such relate to the capital management strategies are provided
adequately. The factors that are required to be taken into consideration while ascertaining the
value-maximizing risk and strategies of capital management are taken into consideration. The
final section provides some real implications for the finance function role in a non-financial
company. The major view asserted by the paper is that the non-financial firms must establish
risk and capital management strategies and such helps to contribute to the shareholder wealth
creation. The value addition by risk, as well as management of capital structure resides
mainly on the specific scenario of the company and the overall risk profile, tax profile,
specific risk, investment opportunities, and the company’s nature. Thereby, the optimum
strategies are completely company-specific and hence are not appropriate to apply formulaic
rules of thumb.
The result provides a clear implication that the larger firms are more exposed to the usage of
derivatives instead of the medium and smaller firms. Going by the discussion, it can be
commented that non financial firms are more accustomed to utilization of derivatives as
compared to private firms. As per the research, it comes to the forefront that one-third of the
firms are not involved in derivatives as the exposures are not clear and another important
reason is the disclosure of the activities as per the FASB regulations.
 

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