Seven Pillars of Hedging Wisdom

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

4. Exposure does not equal risk. Many CFOs focus on their largest exposure and just assume it’s their largest risk, says Koester. That’s not necessarily true. Take, for example, a U.S.-based firm that sources 100% of its production to China — whose currency doesn’t move much — and collects 10% of its revenues in euros. The focus should be on the revenues, says Koester, because of the euro’s volatility. “Risk equals exposure times volatility,” he says. Or, a company may agonize over hedging 200 basis points of interest on $500 million of debt ($10 million) while it has $350 million worth of risk to energy commodities on the trading floor. “CFOs understand fixed- versus floating-rate debt very well, so they’re comfortable talking about it. But the biggest risk for anyone who manufactures is energy prices,” comments Bryant Lee, managing director of Viking Energy Management. “They swing all over the board and pervade everything a company does.”

5. Hedging is not all or nothing. How much a company hedges depends on not only its exposure but also how much pain it can live with, just as car owners set their insurance deductibles based on how many dollars in damage they can absorb. If a company has $5 million worth of exposure on fuel costs, it may say it can live with $2 million of that risk. That means it only needs to hedge 60% of costs, says Lee. More often, especially in the case of energy, companies don’t hedge at all out of fear that prices will subsequently go down, he says. Recently, a customer of Lee’s struck a deal to lock in the price of diesel fuel at $3.08 a gallon, a level where the company could turn a profit and meet earnings expectations. But the price subsequently dropped to the $2.50 range. “Now there is all kinds of internal second-guessing,” says Lee. But if a company doesn’t hedge, its earnings will be 100% exposed to price swings, he adds.

6. Fixed-rate contracts and forwards may be best. “I believe suppliers are more willing to give fixed-price contracts than ever before,” says Wallace of Greenwich Treasury Advisors, “simply because they see a need for it. The buyer has no basis risk, no hedge accounting — what’s not to like?” Not every buyer will qualify for a fixed price, however. Suppliers want customers with exceedingly good credit ratings that buy in large volumes, says Wallace. Buying forward is a popular choice; forward contracts are based on spot pricing and are very transparent. However, a CFO should know the company’s underlying exposure with relative certainty before using forwards.

7. Options don’t have to be expensive. To many companies, using options to hedge is anathema because of the up-front costs. Wallace says that’s due more to human nature than anything else. “It’s a very emotional knee-jerk reaction to paying money up front to avoid a possible future loss,” he says. But there are products with little up-front costs, such as out-of-the-money options. Out-of-the-money options allow a company to lock in a price within a certain range by using calls and puts. Using derivatives can require the application of hedge accounting treatment, however, so the finance department should gauge the impact of hedge accounting before choosing this route.

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