Case Study: Managing risk and hedging in a volatile market

As Sun Tzu said in The Art of War, “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

Sun Tzu evidently underscores the importance of understanding risk and also explains that the flip side of risk is returns

 Knowing the risks either helps in staying hedged or enables making money by riding on volatility. Just as returns are the flip side of risk, properly managed risk is cost saved.

Volatility is here to stay; notice that there isn’t a straight line nor any direction in the commodity or foreign currency and the volatility index. 

Case study: 

The company imports commodity X in US dollars (USD) on sight terms, and it processes and sells consumer packs to its customers in local currency (LCY) through a countrywide local wholesale network on credit terms and then exports to global clients. The sale in local currency is co-related to the commodity, which is quoted on the CBOT. The company enjoys a decent margin of 22% of its sales price.

The company established a high-performing, information technology enabled, and employee engaged organisation which focused on its global footprint and its growth strategy. The structure involved reorganising local treasury teams, setting up offshore treasury centres, and a hub-and-spoke model. The company also set USD as its functional currency for its international business and LCY for its local cash cycle, hedging strategy, policy and process, approved hedging instruments, electronic infrastructure and process, qualified people and incentive plans. 

The company also took an interdisciplinary approach and involved various implementation teams, including senior leadership, organisational experts, information technology experts, traders, sales personnel, accounting and tax teams, treasury and operations, vendors, and specialised service providers. 

The hub-and-spoke model ensured that the business functions received the required attention to identify risks, leaving the spoke to focus on strategy, trading, netting and portfolio hedging. 

Plug and play solutions from vendors, banks and financial institutions ensured quick and validated connectivity with the corporate. 

The company also limited its hedge to approved institutions that were credit approved and managed manually via its ERP systems on a 24x5 basis.  Corporate hedges mainly covered any long-term commitment for purchases and capital expenses, bonds, dividends, and operational expenses. Directional hedges with proper limits and exit strategies were approved for expert traders to manage. 

The company’s ERP systems identified transactional risks at all stages. The systems continuously split both the composite purchase and sales prices into commodity price, the currency, tenor(s), interest rates, and the counterparty risk which enabled identifying and hedging each risk and timings that were generated from individual transactions.  

The company’s systems and traders transferred net information to the hedgers, which then electronically validated and transmitted data to the banks and service providers to enable hedging of commodity price risk, interest rates, and currency risks via the approved instruments and counterparties. The entire system provided agility that took a couple of minutes to hedge, ensuring minimal slippages, a cash flow match and near-accurate pricing.

Once the mundane hedging was performed by information technology, the treasury talent at the spoke was empowered to find innovative, cost-efficient and profitable solutions in the financial and commodity markets, such as natural hedging strategies, forward start hedges, forward hedging of LCY expenses and LCY purchases, relative value credits, investments in secured bonds and liquid assets, portfolio and net hedging, cross-border funding, and currency trading.

All corporate hedging including equity investments, formulating natural hedge structures, options and derivative instruments, forward start hedges for future capex and operating expenses, and illiquid and long term swaps were vested with treasury experts within the corporate treasury team.

Conclusion:

In conclusion, leaving volatility to chance and allowing it to penetrate the organisation could prove to be a recurring nuisance, disruptive and fatal. Volatility can be easily managed and also nurtured for exploiting profitable opportunities. 

However, there is a need for a systematic understanding of the corporate business model, formulation of the right strategy, and leveraging of process, people, technology, and communication that enable clarity of risk and risk management, agility in execution, and innovations around the dynamic business models, market risk environment and volatility.  

Managing volatility and risk is a multi-disciplinary and an enterprise wide approach which also requires focus on engaging employees, customer and stakeholders needs, creative thinking around the supply chain and business needs, collaboration, risk management, and profitable innovation.

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*Producers, plantation companies, farmers, miners and resource extractors face a dilemma in a volatile market. Their approach to hedging can be different unlike a back to back commodity player

or processor.  

-Hedge or not to hedge, it’s an option and has a cost? How to read the market and predict supply and demand, weather, financial market and regulatory driven volatility? Say if you sell today when market is perceived to be higher then what happens when market rises suddenly - entire perspective changes; shareholders start comparing peer performance and risk management policies and management gets blamed. 

So some companies hedge certian portion of the exposurea on a 3 to 12 month rolling basis and leave the balance exposure to price volatility hence their cash flows and EBITDA are directly correlated to the commodity prices.

-Is long term hedging opportunity available? Can companies hedge beyond 18-20 months? Are customers willing to buy long term at fixed prices? Can the cost of production be hedged – note most investments of these companies are in fixed assets, the valuation of which is fixed upfront.