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Articles

5 Key Tactics for Hedging in a Volatile Market

  • By Gopul Shah
  • Published: 7/31/2015

Euro1Commodity, currency, capital and money markets are facing increased volatility, and either price correlations are being broken or new market connections and correlations are being established amidst increasing basis risk.

In current market conditions, where commodity prices are at their lows, most economies and companies are facing economic hollowing and deflationary impacts, shrinking corporate and bank lending budgets, and increasing tax burdens.

Multiple and diverse factors which are interconnected are exacerbating volatility—finance, fuel, food, environment, geopolitics and regulations. Corporates have to grapple with these factors and events, which exacerbate volatility into corporate business models.

In this environment, businesses can thrive or perish. Volatility is challenging companies’ fundamental business models, revenues and cost bases, and thus distorting their cost structure and pricing programs with customers and supply chains. Volatility and inefficient or nonexistent hedging programs distort corporate profitability and cash flows, which in turn translate into credit risk. However, appropriate hedging strategy helps ensure a stable, high-performing and thriving organization that is valued by customers, suppliers, creditors, employees and stakeholders.
 
Enterprise-wide readiness and agility in execution is the answer. Corporates cannot shy away from market volatilities, so being prepared with conviction and courage is the only solution. Corporate risk management has become an integral part of the business strategy, and risk management can make or break the business.
 
Most companies believe that after careful strategic review and analysis of their business model and exposures, as well as regulatory and tax compliance and policymaking, they have the best strategy to hedge the market irrespective of its volatility. However, most research and practical outcomes show that implementation is key to successful execution. Successful implementation is an outcome of people’s actions, their engagement and agility, the interconnected systems, the real-time communication process and the incentive plans, which also include performance and employee behaviors.

The key tactics for hedging are leveraging fundamental principles and going back to basics.

Define principles that clarify risk, policies and strategies to hedge.

  • Define and identify risks that impact the company cash flows and profitability; establish functional currencies, base commodities, funding currencies and policies. Corporates can establish multicurrency functional currencies for different product lines and geographical locations.
  • Create enterprise-wide awareness of exposures in non-functional currencies or commodities. Embed treasury functions into business units to ensure quicker service.
  • Establish transparent real-time exposure, and communication and management systems.
  • Build an organization around the strategy and analyst room, the hedgers, proprietary traders and operations.
  • Ensure regulatory, tax and accounting compliance, and an efficient tax-driven hedge structuring.

Invest in and leverage automation infrastructure that enables a global communication platform, visibility of exposure and agility to hedge.

  • Automate systems with proper data validation, integrity, and controls; multicurrency, commodity and capital product core systems are essential to respond to changes and volatility. Timing differences in creation of exposures and hedging can create unwarranted risks and costs. The market reality is that corporates will have to deal with market-makers that use ‘artificial intelligence’ or ‘high-speed trading’ infrastructure.
  • Identify and legally pre-approve simple and liquid hedging instruments, swap agreements, OTC contracts, forward and futures contracts. 
  • Build relationships and establish connectivity with banks and service providers with appropriate validation. Choose banks and exchanges that offer 24x5 worldwide access to hedging services.

Align action around exposures, profitability and cash flow.  

  • Ensure sales and purchase price breakdown to establish each component of risk; correct market information is exchanged and validated with the traders and the market.
  • Establish exit strategies and a feedback mechanism on what works and what does not.
  • Match hedges with underlying exposures, unwinding with profit and loss and cash flows.

Align and engage people to ensure high performance and innovation.

  • Simplify organization setup, responsibilities and authorities.
  • Maintain high levels of employee engagement and commitment.
  • Align incentive plans that ensure performance, engagement, commitment and appropriate behaviors.

Leverage talent and technology to create profitably sustainable opportunities.

  • A high-performing treasury team can help companies create efficient hedging models and cross-border funding and OTC hedges that are generally liquid.
  • Analytics teams can provide input on macro and micro conditions to establish timings for hedging and profitable opportunities.

Gopul Shah is director, head of global treasury and trade finance for Golden Agri-Resources in Singapore.

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