The Value of OTC Derivatives: Case Study Analyses of Hedges

Over the past 30-plus years, innovations in the OTC derivatives markets have fundamentally advanced the risk management practices of non-financial firms in value-adding ways. These advances in interest rate, currency and commodity derivatives instruments, and the resulting risk management applications, enable US firms to expand globally and be internationally competitive. As a result, these firms can be more successful and achieve business strategies and objectives, despite market volatilities. Academic research shows that derivatives also help lower the cost of capital of non-financial firms, both for debt and equity, and this in turn increases the enterprise value. Overall, the success of non-financial firms in managing risks benefits the macro economy and can help reduce systemic risk.

In the wake of the financial crisis, regulatory proposals were made that would enforce margin requirements on non-cleared derivatives for market participants. Such regulations would limit the ability of non-financial firms to effectively manage risk.

However, an exemption for non-financial companies was included within the US Dodd-Frank Act and European Market Infrastructure Regulation, which excuses those firms that use derivatives to hedge commercial risk from mandatory central clearing rules. Non-systemically important non-financial institutions will also be exempt from posting margin on non-cleared transactions, according to rules finalized by the Basel Committee on Banking Supervision and International Organization of Securities Commission in September 2013. Nonetheless, it is important to note there may be indirect costs for corporate end-users. Dealers will face capital and funding costs from facilitating these trades, and may pass some or all of these costs onto their customers.. Currently, it is not possible to estimate the impact of such a cost transfer.

The approach we are taking in this paper is to assume a worst-case scenario where the corporations are required to post margin. Our study supports the adoption of the no-margin requirement for non-financial firms, since it shows they will face a substantial increase in hedging costs if they are not exempt.

In this study, we investigate the impact if non-financial firms were required to post margin and mark-to-market their positions. It is important to document the potential impact on non-financials if current requirements were reversed. Past testimonies have shown that margin requirements on OTC derivatives hedges would hurt the competitiveness of non-financial firms (FMC Corporation, April 11, 2013). It would also divert money from capital investments and research and development, which would most likely cause lower firm growth and, as a result, would lead to slower growth in the macro economy.

The goal of our study is to further the understanding of the microeconomic aspects from the proposed new regulations of the OTC markets as of August 2013 (before the new margin rules for non-cleared OTC derivatives were finalized). To accomplish this, we examine the use of OTC derivatives by non-financial firms in four case studies, and then replicate the hedges using only exchange-traded derivatives. We first select the largest OTC derivative instruments: interest rate contracts, as identified by the Bank for International Settlements (BIS) in its report on the end-December 2012 global OTC derivatives markets (see BIS 2013).

The first two case studies focus on the use of the interest rate contracts – interest rate swaps. We then select the next largest derivative instruments – foreign currency contracts – and develop case study three, which illustrates a combination of interest rate and currency hedging. The fourth case study focuses on the fifth largest OTC derivatives group: commodity contracts (specifically, natural gas derivatives). The derivative instruments and risk categories discussed in the BIS report and reported in the derivative statistics on the BIS website, including the total notional principal amount outstanding (np) as of December 2012, are as follows:

1. Interest rate contracts: forward rate agreements, interest rate swaps ($489,703 billion np globally; non-financial firms are $34,731 billion np (7.1%))

2. Foreign exchange contracts: forwards and forex swaps, currency swaps ($67,358 billion np globally; non-financial firms are $9,693 billion np (14.4%))

3. Credit default swaps: single-name instruments, multi-name instruments ($25,069 billion np globally; non-financial firms are $200 billion np (0.8%))

4. Equity-linked contracts: forwards and swaps, options ($6,251 billion np globally; non-financial firms are $755 billion np (12.1%))

5. Commodity contracts: forwards and swaps, options ($2,587 billion np; non-financial firms not available)

Academic studies on the use of derivatives by non-financial firms have investigated many benefits in managing interest rate, currency and commodity price exposures. However, there are only a limited number of studies that investigate the interaction between OTC and exchange-traded derivatives, most likely due to the difficulty in obtaining data. Clearly, this is an area where more research is needed. Our study is a step in that direction.

This study proceeds as follows. In the next section, we briefly describe the theoretical and empirical evidence on the value of using derivatives to manage risk by non-financial firms. In Section III, we discuss the hedge accounting treatment for derivatives under Financial Accounting Standard (FAS) 133. In Section IV, we present four case studies of firms using OTC contracts and replicate these transactions utilizing the closest exchange-traded contracts. This section also evaluates the effectiveness of these exchange-traded replications, the resulting accounting treatment, the impact on the earnings per share, and implications for capital requirements if required. Section IV concludes.

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