Hedging
Finding offsets through contract renegotiations, passthroughs, efficiencies, financial products, and derivatives.
Managing Risk
Not doing anything is an option, only if you have a framework in place that helps you understand what that means in financial terms. Based on your analysis, you may conclude that it is best to remain unhedged in some or all your market risks. In reaching this conclusion, you may have found that:
Market risk financial impact is not material.
Hedging alternatives are too expensive.
Your industry does not use market risk offsets, which would put you at a competitive disadvantage if market goes against the hedge.
How can you reach these conclusions using pure intuition?
Most of the time, it is worth doing the homework. There is a lot to learn about the company, its industry and related markets while doing the initial studies necessary for the implementation of a market risk management program. Some arguments for managing risk:
Uncertainty is worth nothing. Some visibility might be rewarded by the market in terms of higher multiples.
It might be the case that market risk is straight forward for the company, links between physical and financial contracts are clear, the cost of hedge alternatives is reasonable.
Your industry engages in hedging activities, an adverse market move might disadvantage the company enough to lose market share or incur unsustainable losses.
A stakeholder, maybe a bank, asks the company to hedge market risks to offer financing.
Measuring and Communicating Risk
Risk means uncertainty. The go-to measure of uncertainty in the markets is the standard deviation. You have most likely heard of volatility, which is standard deviation with a time adjustment.
FROM STANDARD DEVIATION TO VOLATILITY
Steps to calculate volatility:
- Get a time series of the closing price of the underlying asset (source of risk or market of interest)[P0, P1, P2, P3, P4, P5, … Pz]
- Calculate each period’s change in percentage terms( P0 – P1 / P0 ) - 1
- Calculate the standard deviation of the series of percentage changesExcel example: =STDEV.S(C3:C18)
- Annualize the standard deviation, multiplying it by the square root of timeAnnualized volatility = Standard Deviation * (time) ^ (1/2)“time” is expressed in years, and the conversion depends on the periodicity of the data: If daily data is used, (number of days in range / 252)
If weekly data is used, (number of weeks in range / 52) - The result is the annualized volatility !
COMMUNICATING RISK
Once volatility is calculated, you can do several things:
Compare it with the volatility of other markets, of your costs, of your sales prices, and any other data that is relevant to your analysis.
Use it in communications with your stakeholders, hedge providers, insurance companies as a way for them to understand financial impacts of market risk.
Volatility helps communicate risk in terms of VAR –value at risk. In simple terms, VAR is equal to two times (2x) volatility expressed in the dollar amount (or relevant currency) so it can be analyzed in relation to the financial statements. Two times because VAR is a statistical measure of risk at a confidence level of 95. This means that there is only a 5% probability that risk is greater than the reported VAR.
Really understand what it means and find alternative and more useful ways to measure risk, one that makes more sense to management and other stakeholders.
Some less technical, more eloquent, and easy for stakeholders to understand are scenario-based stress tests. Internal use of scenarios is, understandably, preferred. However, for comparison purposes and external communications, VAR is better because it is a flexible statistic that can be converted to daily, weekly, multi-annual, and segmented in different confidence levels.
The Ideal Infrastructure for Risk Management
Are you ready?
The organization knows where it is sitting in terms of market risk. It knows is sources, its measures, and ways to create effective offsets.
It has opened the necessary avenues to execute its strategy. Physical contracts to buy or sell inputs have been offset with pass-through contracts to buy or sell outputs.
The remaining risk has been measured and financial instruments are available to create the offsets. The organization knows the behavior of the instruments that it should use in each situation. Instruments used are appropriate and suitable. It gets competitive pricing from hedge providers.
The economic relationship between physical and financial contracts has been proven, accounts and credit lines are in place to enter into financial hedging contracts. There might be a need to allocate capital to the hedge portfolio and it is available in sufficient amount and at a reasonable cost.
Policies and procedures are in place to facilitate decision making and empowerment to act.
Members of the team involved, from strategy to implementation, record keeping and reporting, all know exactly what their roles and responsibilities are.
Yes, you are…*Suggested research topics: technical analysis, IFRS 9 Accounting Principles.
