Principles of Corporate Finance_ 12th Edition

Chapter 26 Managing Risk 679

bre44380_ch26_673-706.indd 679 09/30/15 12:09 PM

Hedging involves taking on one risk to offset another. It potentially removes all uncertainty,
eliminating the chance of both happy and unhappy surprises. We explain shortly how to set up
a hedge, but first we give some examples and describe some tools that are specially designed
for hedging. These are forwards, futures, and swaps. Together with options, they are known as
derivative instruments or derivatives because their value depends on the value of another asset.

A Simple Forward Contract

We start with an example of a simple forward contract. Arctic Fuels, the heating-oil dis-
tributor, plans to deliver one million gallons of heating oil to its retail customers next January.
Arctic worries about high heating-oil prices next winter and wants to lock in the cost of buy-
ing its supply. Northern Refineries is in the opposite position. It will produce heating oil next
winter, but doesn’t know what the oil can be sold for. So the two firms strike a deal: Arctic
Fuels agrees in September to buy one million gallons from Northern Refineries at $2.40 per
gallon, to be paid on delivery in January. Northern agrees to sell and deliver one million gal-
lons to Arctic in January at $2.40 per gallon.
Arctic and Northern are now the two counterparties in a forward contract. The forward
price is $2.40 per gallon. This price is fixed today, in September in our example, but payment and
delivery occur later. (The price for immediate delivery is called the spot price.) Arctic, which
has agreed to buy in January, has the long position in the contract. Northern Refineries, which has
agreed to sell in January, has the short position.
We can think of each counterparty’s long and short positions in balance-sheet format, with
long positions on the right (asset) side and short positions on the left (liability) side.

26-4 Forward and Futures Contracts

Northern Refineries Arctic Fuels

Long: Short: Long: Short:

Future

production = 1

million gallons

Forward contract

to sell at $2.40 per

gallon

Forward

contract

Forward contract to

buy at $2.40

per gallon

Will require 1 million

gallons

Northern Refineries starts with a long position, because it will produce heating oil. Arctic
Fuels starts with a short position, because it will have to buy to supply its customers. The
forward contract creates an offsetting short position for Northern Refineries and an offsetting
long position for Arctic Fuels. The offsets mean that each counterparty ends up locking in a
price of $2.40, regardless of what happens to future spot prices.
Do not confuse this forward contract with an option. Arctic does not have the option to
buy. It has committed to buy, even if spot prices in January turn out much lower than $2.40
per gallon. Northern does not have the option to sell. It cannot back away from the deal, even
if spot prices for delivery in January turn out much higher than $2.40 per gallon. Note, how-
ever, that both the distributor and refiner have to worry about counterparty risk, that is, the
risk that the other party will not perform as promised.
We confess that our heating oil example glossed over several complications. For example,
we assumed that the risk of both companies is reduced by locking in the price of heating
oil. But suppose that the retail price of heating oil moves up and down with the wholesale
price. In that case the heating-oil distributor is naturally hedged because costs and revenues
move together. Locking in costs with a futures contract could actually make the distribu-
tor’s profits more volatile. The nearby box illustrates that hedging decisions are not always
straightforward.