To expand Last week’s article On hedging, today I highlight why some non-financial companies (i.e., commodity exporters and importers) need to develop a corporate hedging policy. As more and more companies suffer the consequences of not hedging, having such a policy in place is vital. I will highlight the three pillars of building such a policy.
The first pillar is to clearly articulate the hedging objectives that the company seeks to achieve. These objectives should be directly linked to the company’s broader financial objectives such as stable cash flows, hedging against near-term commodity price increases, managing foreign exchange risk or “fixing” profit margins.
The second pillar involves identifying who and what the policy is for. Who is responsible for the hedging policy? Who will be responsible for ensuring the company’s compliance with the policy? Who is responsible for developing, implementing and managing the hedging policy and associated strategies and procedures? Hedging committee, chief accountant, risk manager, etc.?
Who is responsible for selecting appropriate counterparties and/or derivatives brokers/clearing members and what criteria will be used to evaluate them? Who is responsible for ongoing risk monitoring and reporting?
What type of transactions will be allowed? Futures, forwards, swaps, options? What indices will be allowed, such as Dubai/Oman crude oil, ICE coffee futures, Singapore jet fuel, etc.? What resources (manpower, risk management systems, commodity market data, etc.) will these individuals and/or teams need to properly carry out their responsibilities? For example, the effectiveness of risk management metrics, such as stress testing, is essential to assess the degree of business vulnerability under extreme conditions such as a pandemic.
If market trends are unfavourable against the hedged exposure and the derivative fails to meet its hedging requirements (i.e. it does not offset the expected losses of the hedged exposure) or the chosen structure proves to be flawed as described in My previous article on KQThe primary purpose of hedging is undermined. This situation may lead to increased risk and increased use of the company’s credit lines.
The third pillar addresses the practical aspects of executing derivatives transactions, or why, when and how. When and how will existing positions be reviewed to ensure they remain appropriate given the company’s risk tolerance, hedging policy and current market conditions? When and how will the various risks (market, credit, operational and regulatory) be measured and by whom? When and why will transactions be executed?
How often should the policy be reviewed and by whom? This is to ensure that the company is consistently consistent with and does not deviate from its core hedging objectives.
There are clearly many issues to explore when developing a hedging policy, but by adhering to the three key pillars outlined above, companies can ensure that their use of derivatives is prudent, purposeful and optimally designed to meet their specific needs.
A well-designed hedging plan can reduce risks and costs. It also allows management to focus on areas of the company where it has a competitive advantage by reducing risks that are not core to the core business.
Mwanyasi is MD, Canaan Capital