Large Banks, Derivatives and the Economy

17 Jun 2019
Read Time 4 mins
Categories :
Value of Large Financial Institutions

Risk is a pervasive feature of our economy.  Prices, whether they be the prices of commodities, or foreign exchange, or interest rates, fluctuate all the time in response to a changing economy.  These unpredictable changes introduce risk into all of our lives.  Companies that produce the things we use every day are subject to these risks, but dealing with these risks is not their core mission.  Beverage makers want to focus on making tastier soft drinks, airlines want to transport people all over the globe faster (and with less hassle), and auto companies want to build better cars and trucks.  Derivatives provide these companies with a key tool for managing business risks.

In this post, we explore the use of derivatives by large U.S. companies and describe how Financial Services Forum members serve these companies by providing them with access to derivative markets to manage risk.

While there are many different types of derivatives, an important derivative that is widely used to manage risk is a forward contract.  A forward contract obligates a buyer and a seller of a particular good, such as sugar, to exchange the good at a pre-determined price at a specific future date.  Forward contracts linked to commodities have been around since the time of the ancient Sumerians (8000 B.C.) and were designed to help farmers (e.g. sugar farmers) and commodity users (e.g. bakers) avoid uncertainty about future prices by agreeing on a price today for a commodity that won’t be delivered until after harvest.  This fundamental desire to mitigate the risk of uncertain prices is as important today as it has ever been.  And all types of companies use derivatives, such as forward contracts, to reduce the risk of unforeseen changes in the prices of key inputs, which then translates into more stable prices for consumers.

Figure 1 shows the market value of derivatives held by the companies in the Dow Jones Industrial Average (Dow) in 2018.  As shown in the top panel of the figure, the top five users of derivatives comprise a number of household names that make everyday products familiar to most everyone, such as iPhones (Apple), baby powder (Johnson & Johnson) and prescription drugs (Pfizer).  The bottom panel shows how derivative usage varies across other Dow companies.  So, while not every Dow company uses derivatives as extensively as Apple, other large U.S. companies, such as General Electric, Nike and Boeing, also use derivatives to reduce risk.


So why exactly are these companies using derivatives?  One way to answer this question is to look at the specific statements made by each company in their financial reports, which provide a window into how derivatives are used.  Table 1 provides a breakdown of the specific reasons cited by Dow companies that use derivatives to manage the following types of risk: exchange rate risk, interest rate risk, commodity price risk and other risks, such as equity price risks.  As shown in the table, exchange rate risk (26 cases) and interest rate risk (26 cases) are the most commonly cited risks while commodity risk (11 cases) and other risks (7 cases) are cited less frequently.

Table 1: Rationale for Derivative Usage: Dow Firms

Industry # of Firms Exchange Rate Interest Rate Commodity Other (Credit, Equity, etc.)
Consumer Discretionary 7 7 7 1 1
Health Care 4 3 3 0 0
Telecommunications 1 1 1 0 0
Technology 4 4 4 1 4
Industrial Materials 1 1 1 1 0
Consumer Staples 2 2 2 2 0
Energy 2 2 2 2 1
Financials 3 2 2 0 1
Industrials 4 4 4 4 0
Total 28 26 26 11 7

Source: Firm specific 2018 10-k reports, available at https://www.sec.gov/edgar/searchedgar/companysearch.html

Each risk category in Table 1 is an important source of risk for large companies and the broader economy.  In the case of exchange rate risk, a company like Apple may purchase a key production input, such as rare earth magnets used in cell phones, from a foreign country.  As a result, it may use a foreign exchange forward to reduce the risk that the foreign currency cost of the key production input rises significantly.  In the case of interest rates, a company like Caterpillar may borrow money on an ongoing basis to finance the production of its heavy equipment and may want to lock in interest rates today on money it knows it will need to borrow in the near future.  Finally, a large consumer goods manufacturer, such as Nike, may use commodity forward contracts to manage the risk that the rubber used in its sneakers does not increase in price significantly and result in increased prices at the check-out counter.  For all of these reasons and more, companies rely on derivative markets to help them manage risk.  And better managed risk translates into more certainty and less volatility in prices and product availability for consumers.

In the United States, derivatives are largely provided to companies by large U.S. banks, such as Financial Services Forum members.  Figure 2 below shows the fraction of derivatives held by Forum members relative to all U.S. bank holding companies across each of the major risk categories in Table 1.  In many cases, Forum members hold these derivatives as they provide access to derivatives for the companies that need them.  As a specific example, when a company wants to engage in a foreign exchange forward contract it will agree to purchase a specific amount of foreign exchange (e.g. 10 million Euros) at a future date (e.g. 1 month from now) directly from a large bank.  The bank will then take that position and search for another market participant who is interested in selling an equal amount of foreign exchange on that future date.  In this way, the dealer “completes” or “intermediates” the foreign exchange forward market by matching would-be buyers and sellers of foreign exchange.  As shown in Figure 2, among U.S. bank holding companies, Forum members account for the overwhelming bulk of derivative activity.  These amounts do not include amounts held by foreign banks in foreign countries and many large companies use large foreign banks to access derivative markets as well.  In the U.S. context, however, Financial Services Forum members are the leading source of access to derivatives for companies that need them to manage risk.

 

Derivatives are an important risk-management tool used by a large number of companies that produce a wide array of products and services that are important to businesses, households and the broader economy.  In the U.S., Forum members play an integral role in providing companies with access to derivatives.

Derivatives provided by Forum members helps companies reduce risk so they can focus on their core mission and provide their products and services to their customers and the broader economy with less risk and greater stability.

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