The Impact Of Hedging With Derivatives On Earnings Volatility

Along with the development of the capital market and the increasing needs of risk management all over the world, more and more corporations start to make use of derivative instruments in their risk management practices. According to the theory of hedging, the basic principle of hedging by derivatives is that the changes of the fair value or cash flow of derivatives will counteract the changes of the fair value or cash flow of the hedged items. Thus the volatility of earnings can be reduced. As an instrument for risk management, however, derivatives themselves are of high risk. Whether hedging with derivatives is a suitable and rational way for corporations is hotly discussed in theoretical cycles and practical operations.Based on Modern Hedging Theory, this paper chooses Jiangxi Copper Limited Company, which is a Chinese public company, as the object of this case study and analyses the impact of hedging with derivatives on the company’s earnings volatility. Firstly, this paper introduces three hedging theories and then theoretically analyses the relation between hedging and the earnings volatility. Secondly, this paper elaborates Jiangxi Copper Co., Ltd’s hedging strategy and hedging practices in different market conditions. Finally, through comparing the different earnings volatilities when the company operates with or without hedging with derivatives, this paper analyses the impact of derivatives hedging on the reported earnings volatility. The results of this research are as follows:(1) Overall, hedging with derivatives reduces the volatility of earnings.(2) Copper futures and related derivatives’reduction effect on earnings volatility is more significant when the market trend is not clear or predictable, or when the income of the corporate is more related with the price of copper. (3)The foreign exchange forward and interest rate swap respectively has little impact on earnings volatility.(4) The more types of derivatives are applied, the reduction effect is more significant.At the end, this paper gives some suggestion for corporations in hedging practices.