Before a company enters into any hedge, it first needs to
understand what its risks are. At first blush, this sounds elementary, but in
the world of commodities understanding what the company is exposed to means
considering the various inputs of its finished products. For example, these
might be all the commodities that comprise a food and beverage manufacturer’s
bottles or an automobile manufacturer’s cars.
Most commodities are
purchased under contract or tender, which may specify fixed pricing – in which
case there is no risk. Floating price contracts create risk. Treasury needs to
examine all procurement contracts to identify where risk lies. For example, the
beverage company must consider the cost of all the types of plastic that goes
into making a bottle of orange juice: the oranges, sugar for sweetening, the
plastic in the bottle, the polyethylene terephthalate (PET) in the bottle cap
and even the paper label. The car manufacturer might consider metals exposure –
both base and precious: the steel, aluminium, palladium, platinum, or the rubber
in the tyres, plastics for the interior or copper in the copper wire. But if
copper wasn’t difficult enough to price, for example, the price of the plastic
coating around the copper wire may have no market on which to base a price,
although it forms part of the exposure.
Also, there is often no market to
base the cost of shipping these materials to the manufacturing plant. These
extra costs, or basis cost, are additional exposures that treasury needs to
consider in collaboration with procurement, financial planning and analysis, and
accounting. Getting this right is critical to the bottom line, especially for
companies whose products yield narrow margins such as the makers of aluminium
The basis forward curves for such exposures are unique. This is a
market data issue, which impacts the ability to value forecast exposures. There
are no publicly-available curves for delivering palladium from the US to a
factory in Europe, for example. Of course, there are transport costs to
estimate, but to make that into a curve of a car maker’s palladium input cost is
difficult and requires analysis of actual costs and assumptions about their
future applicability. Consequently with commodities, an exposure that a
treasurer might be trying to hedge is never perfectly matched by the derivative
(which always has standardised contract terms), unlike, say, a yen exposure,
which can be hedged with a yen/dollar (JPY/USD) forward. Consequently, when a
company looks at its exposures it has to understand the exact nature of its
commodity exposures. So, for example, it might not only be aluminium but
aluminium delivered to a factory somewhere.
The Holistic View of
As commodity hedging is complicated, many commodity
exposures are just not hedged. Sometimes standardised derivatives contracts
aren’t representative enough of an actual exposure, derivatives just don’t
exist, or the market is too thinly traded (for example rice, plastics, hot and
cold rolled steel). Even when a company knows its exposures and its basis cost,
there is often only some subset of that it can hedge.
If a company can
only hedge some of its product’s components, it needs to then decide which of
those components it should hedge and how much it should hedge. In addition, it
needs to understand the impact of the exposures that it doesn’t hedge on the
exposures it could hedge. These decisions come down to understanding exposures
individually and understanding them collectively. So the unhedgable PET in the
beverage manufacturer’s bottle of orange juice could be negatively correlated to
the hedgable cost of oranges, for example. Only tools such as cashflow at risk
(CFaR) can shed light on these issues. Scenario analysis cannot help in this
case as it neither takes correlations into account nor the passing of time.
Commodities and Currencies
Best practice today is to look at commodity
exposures and foreign exchange (FX) exposures together. This is because global
manufacturers are usually positioned short for commodities and long for
currencies, selling product globally. It is useful to group currencies together;
for example dollar bloc, yen bloc, euro bloc and commodity bloc, as commodities
can be negatively or positively correlated to different currencies. Base metal
(copper, steel, and aluminium) prices, for example are correlated with the
Australian dollar (AUD), Brazilian real (BRL) and South African rand (ZAR).
Along with long currency and short commodity positions, correlations often
create natural hedges, which can mitigate the need for hedging in some cases.
For commodities that can’t be hedged, this can be particularly helpful; for
example to vehicle manufacturers or metal fabricators selling globally.
Intelligence from Cashflow at Risk
As well as providing an understanding
of the interaction between risks, CFaR can be used to provide actionable hedge
recommendations to optimise (minimise) CFaR, within the limits of hedge cover
targets. The same approach can also be used to validate hedge cover targets, to
ensure that they result in optimal risk management.
Figure 1 below shows
CFaR contributions by asset class of a large multi-asset class portfolio;
Figure 1: CFaR Contributions by Asset Class: 95th Percentile & Time
Horizon = One Year
Figure 2 below shows the CFaR
distribution of an unhedged and hedged portfolio to visualise the impact of
Figure 2: CFar: One Year Time Horizon Histogram.
In addition to the foregoing, the decision to
seek hedge accounting treatment for commodity hedges, requires analytical and
statistical tools beyond those needed for interest rates (IR) and foreign
exchange (FX) hedge accounting. This is because current accounting standards
require the designated risk of commodity hedges to be the all-in price risk of
an exposure; for example the copper wire and not the copper in the wire.
The ‘basis’ issue described earlier requires robust statistical techniques
such as regression to test the strength of relationships between standardised
derivatives and custom commodity curves. Historical costs need to be gathered to
make future estimates of ‘basis’ and used in exposure forward curves to value
exposures. Even having obtained successful commodities hedge accounting, there
is still the issue of release of other comprehensive income (OCI) to match
actual receivable or payable that was hedged as a forecast. This usually results
in a drip release over a period of time.
Lastly, there are often cases
where a derivative provides a good economic hedge of an exposure, although it
does not qualify as an accounting hedge. Corporates need to be able to, at the
very least, apply fair value to the derivative which will add volatility to a
company’s income statement.
Commodity hedging presents a
number of challenges to corporates over and above that of other financial risks
and requires collaboration and communication with other groups of financial
professionals in the organisation.
In addition, with the help of advanced
analytics and cloud-based treasury and risk management technology that enables a
holistic view of risk across the enterprise, other challenges can be addressed.
They include measuring and defining commodity risks; understanding their
interactions with other financial risks; seeking hedge accounting and satisfying
the requirements of accounting standards; and finally accounting for commodities
derivatives in conjunction with the commodities payables and receivables that
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