International Financial Management 1

International Financial Management 1

Running Head: Derivatives

Hedging Techniques

Introduction

Incurrentbusiness environment, organizations are engaged to operate their business activities around the globeand due to this; they expose various kind of risks. Hedging can be defined as a process through which organizationsare used to manage foreign exchange exposure.Through this, they are tried to eliminate or minimize such loss that occurs due to change in currency rates, interest rate and commodity price (Madura, 2011). Previously, the 3M company known as the Minnesota Mining and Manufacturing Company. It is a USmultinational conglomerate corporation based in Maplewood, Minnesota. This paper will identify several techniques thatare used by 3M to minimize its risk in global market.

Hedging Techniques

Following are sometechniques that areused by 3M to hedge currency, interest rate and commodity price risk in effective manner:

Forward Contract:3M uses forward contract for minimizing such risk that is exposeddue to currencytransaction. Due to global operations, it is engaged to make or receivepayments indifferent countries and currencies accordingly. The fluctuatingcurrency rate exposescertain risks for the company. Forward contract can be definedas an outright agreement that allows exchange of currencies at a predetermined rate in a future date (Hamilton & Booth, 2007).

If3Mis obliged to paycertain amount inJapanese yenafter two months then any increase in this currency price may create loss. For hedging this loss, 3M is entered in a forward contact with other party anddue to this; it will be enabled to purchase yen in the pre-determined price.Any increment in yen will not influence company’s cash position (Mayo, 2010). Through this, it is enabled to maintaincurrency risk and cash position accordingly.

This hedging technique is helped to limit the loss that incur due to increase and decreasein the price of currency.3Mpurchased Japanese Yen, Pound Sterling, and Euros with anestimated amount of $255 millionat the predetermined rates by entering into foreign currency forwardcontract in November2008. In early January 2009, the hedge value of above currencies matured and gainsor losseswere used to offset the underlying tax obligation (3M, 2011). The global operation exposes different tax obligationsthat are fulfilled by 3Mwith the gain-loss of foreign currency forward contract (Weaver & Weston, 2004).The relationship between foreign currency forward contract and cash flow goes negative in the given company. In 2011, this company is in the negative cash flow position in relative to 2009 and 2010. Forward contract incurred net loss of $42 million in 2011 (3M, 2011).

Option Contract: This hedging technique is also used by 3M to reduce such risk that occurs due tofluctuation in currency and commodity prices. Options can be defined as \hedging technique that offers rights to contractual parties for buying and selling a specific amount of asset either commodity or currency at an exercise/strike price within a specified period, after which the option expires.Normally, buyer of the option pays a premium to the seller (Melicher & Norton, 2011). Such option agreement that gives right to the holder to buy the asset can be defined as call option. In contrast, if it gives right to sell then it is termed as put option.

3M usesthis option contract to hedge the risk that occurs due to fluctuation in currency.On the basis of fair value, this company estimatesfuture rates of currencyand it is used to analyze its impact of future cash flow. This company is engaged to manage its cash flow position effectively with the use of option.If 3M is about to make paymentinforeign currencyafter a specified period then it uses call and put option (Chew, 2010).Due to use of option contract, this company is enabled to maintain cash flow position by $3 million in 2011. By using option contract, the given company has managedthe risk that contains each currency transaction.A significant income is realizedby the company due to effective use ofoption contract. In 2011, total $13 millionincome is realized by this company from theoption contracttransactions (3M, 2011).

Interest rate swaps Contract: For managing borrowing rates in effective manner, 3M uses interest rate swap contract. It can be defined as an agreement that allows a company to change its borrowing rate either from floating to fixed or vice-versain a specifiedtime. In order to execute operations successfully, this company is engaged to borrow finance for short and long term both.The borrowing cost plays a critical role to influencecash positionof 3M as it is responsible tomake significant reduction in earnings.If this company is estimated that fixed rate of borrowingis about to increase then it enters in interest rate swap (Besley & Brigham, 2007). With this, the company enables to maintain or reduce its borrowing costin effective manner.

3M usesinterest rate swapfor converting the note of $800 million into a floating rate. Thisinterestrate swap matured in the fourth quarter of 2011 (3M, 2011). Due to use of interest rate swap, the companyfaced negative impact on its cash position as a net loss of $10 million dollar is accounted at the end of 2011.

Commodity Price Swap Contract:It is used by 3M to reduce such risk that is exposed due tochanges in the price of commodity. This contract is based on theprice of underlying asset such as sugar, oil, gas etc.For offsetting the impact of fluctuations in cost that isassociated with the use ofpreciousmetals and gas, this company is engaged to use commodity price swaps. There are mainly two commodities such as gas and oil for which this company isengagedto use commodity swap contracts (Jones, 2009). By managing cost of oil and gas, this company has managed theoperational cost and cash flow position in effective manner.

In 2010 and 2009, company has estimated negativeinfluenceover cash positionof total $13 and $10 million respectively from the commodity swap. In 2011, the negativeinfluencedover cash flow position has been reduced and remained at$4 million. At the same time, for managingrisk of commodity price, 3M also used negotiated supply contracts, forward physical contract andprice protectionagreements as well (3M, 2011). With this, 3M is engaged to maintain the price of commodities that it is used in production and to mange cash flow position accordingly.

Conclusion

From the above discussion, it can be concluded that 3M usesdifferent hedging techniques for reducingdifferent risks such as commodity, interest rate and currency.The motive of all hedging techniques is to manage the cash position of company in effective manner. In 2011 and 2010, currency and hedging impact isresponsible toincrease net incomebyapproximately $154 and $15 million respectively. At the same time,derivatives andother transactions areresponsible to decrease the net income by $115 million in 2010 and successively in 2011 (3M, 2011). The data shows that 3M is effectively managed the currency risk. On the otherhand, it is not usedderivatives to manage the other risk such as commodity and interest rate.This company should focus over the management of commodity andinterest rate fluctuations. For this purpose, it should use the interest rate swaps and commodity price swap more effectively.

References

3M (2011). Annual Report. Retrieved from:

Besley, S. & Brigham, E.F. (2007). Essentials of Managerial Finance (14th ed.). USA: Cengage Learning.

Chew, D.H. (2008). Corporate Risk Management. USA: Columbia University Press.

Hamilton, R.W. & Booth, R.A. (2007). Attorney's Guide to Business and Finance Fundamentals (2nd ed.). USA: Aspen Publishers Online.

Jones, C.P. (2009). Investments: Analysis and Management (11th ed.). USA: John Wiley and Sons.

Madura, J. (2011). International Financial Management (2nd ed). USA: Cengage Learning.

Mayo, H.B. (2010). Investments: An Introduction (10th ed.). USA: Cengage Learning.

Melicher, R.W. & Norton, E.A. (2011) Introduction to Finance: Markets, Investments, and Financial Management. (14th ed). USA: John Wiley and Sons.

Weaver, S.C. & Weston, J.F. (2004). Finance & Accounting for Non-Financial Managers. USA: McGraw-Hill Professional.