Corporations, especially those with indirect exposure to commodity risk, have hi
ID: 1211587 • Letter: C
Question
Corporations, especially those with indirect exposure to commodity risk, have historically taken a passive approach. Using such an approach, companies have tended to categorize unfavorable price movements as a cost of doing business and either pass the cost increases through to the consumer or absorb them. One alternative is to always hedge. For example, at the first of the month the company might commit to buy some of its upcoming need, using futures, forward trades or options. That will smooth out the company’s actual prices, though it cannot eliminate price risk. Before engaging in a hedging program, though, it is vital that corporate management understand the challenge. Delta Airlines, for example, hired a seasoned commodities expert to run their fuel cost hedging program. They thought he was great when oil prices rose; his hedges limited the company’s exposure to the price increase. Then they thought he was inept, when prices fell and the hedges cost the company money. That’s the essential nature of hedging, though. You gain from the hedge when price moves against you, but you pay when the price moves in your favor. Unfortunately, some executives don’t think that the “pay” part of the hedge should ever occur. If that’s the level of understanding of your management team, do not hedge your cost exposure. Here are some typical company approaches to hedging program strategies: The “price fixer” wants protection against rising prices, at relatively low cost, using instruments such as swaps and futures to lock in a fixed proportion of input requirements. While there’s little opportunity to gain from decreases in commodity prices, the arrangement does offer price certainty – a valuable feature if the concern is over the volatility of input costs. The “opportunistic hedger” hedges a portion of the input exposure, but with more active management of positions and use of more complex techniques such as calls, puts, collars, and spreads, in an effort to extract additional margin based on market volatility. This approach, however, comes with a higher cost and potential risk exposure. The “active hedger” exercises more flexibility in price exposure, with a higher likelihood of large gains or losses from the hedges depending on the hedger’s view of the market. This strategy may include speculative positions that require daily monitoring using a well-defined framework of controls. Companies that have a fundamental view of the market stemming from their leading roles in physical sourcing and relatively mature trading and risk management systems and processes tend to adopt this approach.
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