Seven Pillars of Hedging Wisdom

In volatile markets, it pays to keep an eye on the foundations of effective hedging.

Recent fluctuations in currencies and commodity prices have once again highlighted the importance of hedging expertise. The dollar’s continued rise against the euro, pound sterling, and Australian and Canadian dollars promises to eat into the operating income of companies that earn the bulk of their revenues in those geographies. Crude-oil prices journeyed from the low $70s to almost $90, then dipped below $70 — all in four and a half months, making it difficult for companies of all types to forecast energy costs. Global sugar prices soared to historical highs earlier this year, then halved, wreaking havoc on the input costs of food producers.

Exposure to currency risk is widespread across industries. In a 2010 survey by the Association for Financial Professionals, 51% of organizations said they have an exposure to foreign-exchange risk, and 72% of them hedge their exposure. Only 13% of companies are exposed to agricultural commodity risk, but 80% of those companies said that exposure has a “significant” impact on profitability.

Unfortunately, in their rush to tame risk, some companies leap into hedging before looking at their appetite for risk, identifying their objectives, or evaluating hedging tools. Reviewing the first principles of a hedging strategy is essential, even for companies that have hedged in the past. To help with that review, here are seven pillars of hedging wisdom, based on interviews with several experts.

1. The only good number is zero. Beware both big gains and big losses from hedging. When companies make money off hedging, they tend to forget what their core businesses are, says Ryan Gibbons, managing partner of GPS Capital Markets. “Your job is to mitigate the risk and protect margins, not make money off of currency moves,” he says. If finance executives profit from a hedge, they start to think they are playing with the house’s money, he adds. “When an analyst looks at your company’s FX gains and losses line, the only happy number for the analyst is zero,” says Gibbons. “When you make money, the analysts beat you up because you’re taking too much risk, and when you lose it, they beat you up because you’re not hedging enough.”

2. The wrong people can spoil a hedging program. The CFO has to assign suitable personnel to this risk-management function. To hedge commodities, for example, a firm needs deeply informed buyers who are aware of the macro issues affecting supply and demand, says Jeff Wallace, managing partner of Greenwich Treasury Advisors. A smart setup is to have a joint treasury, purchasing, and operations team executing hedging strategies. Strategy, of course, needs to come from the CFO, guided by the CEO’s thinking on corporate risk appetite.

3. A hedging strategy is only as good as your data. CFOs have to question the data coming out of operating units and determine what their confidence level in that data is, says Gibbons. Does the finance chief trust the data on sales dollars, input costs, and fuel usage in the supply chain? How much delay is there in the data? The answers will determine a company’s exposure and to what degree it hedges. “If CFOs only look at currency exposures 10 days after the end of the month — and only once a month — they are less likely to hedge all their exposure, because they are not confident the data are truly representative of their current exposure,” says Wolfgang Koester, chief executive of FiREapps, a vendor of software for managing foreign-exchange risk. CFOs need timely data, better transparency to their data, and certainty that the data are complete.

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