Reduce Pricing Risks With Effective Hedge Strategies

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Reduce Pricing Risks With Effective Hedge Strategies

Hedge transactions made simple.

February 3, 2011

by Ron Box, CPA.CITP

Risk is an unavoidable fact of business life. The strategies that we use to recognize and mitigate risk can often determine the success or failure of a business. One of the most important, yet often misunderstood, mitigation tools is the hedging of financial risk. What steps can an average business take to offset unfavorable swings in commodities and interest rates? When effectively conceived and executed, hedging can benefit companies of almost any size. Hedge transactions do not have to be complicated and they do not have to be the province of large companies.

Hedge Programs Explained

Consider hedging as a form of insurance against certain forms of financial transaction risk. Two of the most common financial risks that can be offset by a well-constructed hedge program will help protect against price swings in commodities and interest rates. There are several mechanisms that are used for such transactions that can involve futures contracts, short sells and rate swaps, among other more exotic positions. Financial executives entering into their first hedge offsets should first devise a specific set of guidelines that clearly outline:

The Risk to Be Hedged Define the specific risk that you wish to offset. Interest rate and commodity price concerns will generally require different mechanisms to offset, so each will require separate strategies.

How the Risk Will Be Measured Determine the basis for establishing the initial pricing for the interest rate or commodity. This requires an in-depth knowledge of the market behavior that you wish to hedge against (often called visibility). Research the drivers of market pricing and seek guidance from professionals that can provide background for your inquiry. Develop a structure to incorporate your findings in to a workable model to track and measure the results of your hedge activities. Tracking the long-term success of the program is an important step in managing best practices.

Selection of Appropriate Hedge Strategy Choose your hedge strategy carefully based on your understanding of the risks that you wish to mitigate and the best options available for offset. There are many ways to hedge risk. A few of the basic strategies for interest rate or commodity hedge programs are:

Interest Rate Hedge Swaps are used to hedge many interest rate risks. Essentially, rate swaps are an agreement between two counterparties exchanging one stream of future interest payments for another. Interest rate swaps can exchange a fixed payment for a floating payment or vice versa, depending on the strategy you wish to employ.

Commodity Hedge There are many ways to hedge against commodity price risk, but one of the most straightforward mechanisms involves the purchase of a futures contract, guaranteeing a particular price at a certain point in time. In this case, the price is guaranteed and no unexpected loss can occur. Of course, no gain based on favorable price changes can occur either. Another option is to enter a short sale against an investment that you believe performs inversely to the commodity that you wish to hedge. In so doing, the gain you experience in the decline of the short sale can offset price increase in your commodity. There are other commodity hedge options, so research the best one to suit your needs.

FASB 133/IAS 39

With any hedge program, you should be aware of the accounting standards that will govern the reporting of those transactions. FASB 133 and IAS 39 (IFRS) (PDF) In part, the summary under FAS 133 says: Under this Statement, at the inception of the hedge, an entity that elects to apply hedge accounting is required to establish the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. These methods must be consistent with the entity’s approach to managing risk. Corporate Finance Insider readers should note that Statement no. 133 was superseded after it was codified in section 815 of the FASB Accounting Standards Codification. As such you should carefully research the sections of FAS 815 and IAS 39 that apply to your hedge program.

Advice on Hedge Programs

According to Tod Ferguson, senior relationship manager for corporate banking at the Royal Bank of Canada United States subsidiary, many financial executives moved away from commodity hedge transactions after the financial crisis. The hedge environment was somewhat unpredictable after the crisis and this led many finance executives to defer the use of hedge transactions that might have otherwise been useful. Some experienced traders had set a properly constructed hedge based on 2007 volume, but when the volume changed significantly in such a short time they found themselves over hedged versus the new need. With so much volatility in the commodity markets caused by the recession, a number of traders opted on the side of caution and reduced or eliminated the number of hedge transactions. With the economy showing signs of recovery, it may be time to reconsider the consistent use of well-conceived commodity hedge transactions.

Ferguson recommends that commodity hedge transactions could be beneficial in today’s market. Consider the following points as you determine the risk mitigation plan for your organization:

Make sure that the counterparty in the hedge transaction is reliable.

Be as certain as possible that the ultimate customer for which you are hedging the transaction will perform. Deferral of the sale could cause your transaction to go beyond the expiration date of the hedge, which renders the hedge an unnecessary cost and leaves you un-hedged when the transaction occurs. Even worse, the ultimate customer could renege on its contract altogether leaving you with a hedge against a transaction that will not occur.

You do not necessarily have to hedge 100 percent of the transaction. Unless you have great visibility regarding the market and a clearly defined sales contract, you might want to hedge only a portion of the transaction, such as 70 percent to 80 percent of the transaction. By so doing, the risk of over hedging is diminished.

Layer commodity hedge transactions whenever possible. It is often impossible to perfectly time the market, but layering hedge transactions can make it more likely you achieve favorable pricing. This strategy also allows for a quick change in the amount of hedges you place if conditions change.

Do not try to time the market waiting for the perfect time and price. Your objective is to hedge your cash-flows, therefore you need to make the best judgment possible for the time and place but recognize that you are managing risk, not trying to win a bet on market price movements.

Commodity hedges can provide a great competitive advantage over your competition. Hedging can lower your costs or at least reduce the volatility over time and provide serious benefits in pricing your product as well as predicting your cash flows.

Educate yourself on the fundamentals of the hedge market issues. Try to create visibility on the critical issues relevant to the fundamental factors important to your operation. The more you know about the commodities needed in your manufacturing operation and how best to hedge those material needs, the more you can provide pricing advantages for your firm.

Mitigating financial risk with hedge transactions can be very helpful to businesses of all sizes, particularly as those risks become more pronounced. Many circumstances beyond the control of financial executives can affect the commodities critical to business operations or the interest rates required for capital. The turmoil in Egypt has disrupted the commodity price of fuel, copper prices have been volatile on supply concerns and many believe that continued deficit spending will create severe inflation with related spikes in interest rates. These events cannot be directly controlled. However, the effect of such events on your business can be offset by effective hedge programs.