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Market Update November 2009
Hedging Commodity Risks
Hedging interest rate or foreign exchange risks are focal points of most company’s risk management. And while these risks are usually actively managed, commodity risks are too often treated as pure operational cost.
Since fluctuating interest rates or exchange rates are classified as financial risks by most companies, treasury or finance departments are usually responsible for identifying and reducing these risks using financial instruments where possible and feasible.
Commodity risks, on the other hand, are often perceived as operational components in the production process. The purchase department is usually responsible for the management of these costs, with the focus more on finding the cheapest supplier, improving logistics and optimising stock levels rather than reducing the risk of commodity price volatility.
The larger the volume of commodity purchases and impact on the operational profit are, the more important a pro-active management of commodity prices becomes. This is even more so the case, as commodity prices have been far more volatile than major exchange rates in recent years (see chart).
Hedging Alternatives
Hedging is possible for a number of commodity exposures such as: fuel, natural gas, aluminium, copper, steel, tin or zinc. The most common over-the-counter hedging instruments are:
Forwards: Used for shorter term hedges; the cash flows generated by the forwards offset the price volatility cash flows on the underlying commodity exposure.
Swaps: Used to exchange fixed and floating payments; usually to hedge recurring commodity purchases or sales.
Options: Allow companies to cap commodity costs while participating in favourable price movements.
PMC has assisted numerous clients in determining their commodity risk exposures, analyzing the risks involved, identifying natural hedges and designing & implementing risk reducing hedging strategies. Our market-based pricing models allow us to provide benchmark pricing to ensure best pricing in a hedging transaction. Please contact us if you want to know more about commodity hedging.
PMC Treasury is an independent corporate treasury advisory firm with clients throughout Europe, the US and Asia-Pacific. Started in 1989, PMC consultants advise clients on operational treasury matters such as treasury functions, best practices & controls as well as interest rate, currency & commodity hedging.