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.

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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