In this article, we look at some approaches to hedging, including the use of over-the-counter derivatives and natural hedges.
Approaches to Hedging
One CPG company has a sophisticated hedging strategy for managing supply price risks for a wide variety of commodities such as natural gas, coffee, electricity, pulp/paper, etc. They use a combination of traditional approaches—knowing supply markets well and tracking the fundamentals—along with treasury instruments for mitigating currency and interest rates. They have a four-person organization with expertise in treasury to manage currency risk, and in procurement to understand what is going on with the commodities across the company and manage that risk. There is synergy in combining these two disciplines. Having treasury and purchasing working together instead of arguing about who should call the shots is a good practice.
The firm has preferred ways of hedging. Their priorities provide some examples and insight into the basic approaches available:
Customer surcharges—Their first choice is to have contracts with their customers that enable them to pass on the commodity price fluctuations. However, some retailers, Walmart for example, refuse to accept that risk.
Supplier Price Guarantees—If the customer will not agree to a surcharge, their second choice is to get price protection or price guarantees in the supply contract. But it is important in that case to ensure that the suppliers can support those price guarantees (see below: Price Guarantees Should Be Vetted for Viability).
Hedging Instruments—When price guarantees are not possible or adequate, their third choice is buying hedging instruments on the financial markets. For agricultural commodities such as coffee and bean oil, they can use normal futures options. If necessary, they will negotiate an over-the-counter instrument (see below: Over-the-counter Derivatives).
Price Guarantees Should Be Vetted for Viability
This company will only ask suppliers to include price guarantees in contracts if they are confident that the supplier can financially support the guarantee for a period of time. It is important to understand how the supplier is able to offer the price guarantee. If the supplier is vertically integrated, with their own sources of raw materials, they may be insulated from raw material fluctuations. Alternatively, the supplier may purchase hedging instruments in the open market. But absent either of those, the supplier is exposed, and may not have the financial resources required to absorb big increases in raw material prices. This CPG firm learned its lesson the hard way when natural gas spiked several years ago, climbing from $4/MMBtu to $10/MMBtu. Some of their distributors hadn’t hedged and as a result went bankrupt, at which point the price guarantees were of course worthless. Since then this company’s buyers require suppliers to hedge their price guarantees and show how many months out they’ve hedged.
Hedge Accounting and FASB 133 Compliance
Derivative financial instruments are used to hedge risks, such as interest rate risk, foreign exchange risk, and commodity risks. Accounting for these derivative instruments is covered by FASB 133 (US Financial Accounting Standards Board’s rules) and IAS39 (in countries using International Financial Reporting Standards—IFRS). US GAAP and IFRS require that changes to the market value of derivatives be taken to the P&L account, which can cause significant P&L volatility. This P&L volatility can be mitigated using hedge accounting to provide an offset to the market movement of the derivative. However, hedge accounting requires a large amount of compliance work documenting the hedge relationship and proving that it is effective.
So, when hedging, it is important to understand and comply with FASB 133. To qualify for hedge accounting, hedging relationships have to have a correlation ratio between 80% to 125% in achieving offsetting changes in fair value or cash flows for the risk being hedged.
FASB 133 also changes what things are considered to be derivatives. Unless the company can show that a commodity (e.g. natural gas) they are buying will be used over a “reasonable period of time” in the normal course of business, the POs for those commodities are considered to be derivatives under Statement no. 133, even though companies may not intend to use those contracts as derivatives.
When exchange-traded derivatives are not available for hedging a particular commodity, companies may opt to buy an over-the-counter (OTC) derivative, which is a contract negotiated directly between two parties, without going through an exchange or other intermediary. Products such as swaps and forward rate agreements are usually traded this way. There is an industry standard over-the-counter base instrument for hedging, created by the ISDA (International Swaps and Derivatives Association).1
OTC derivatives may be paid for upfront, or their cost may be built into the price the buyer pays for a commodity (such as paying a premium in exchange for a guaranteed price). In either case, the buyer should look at the total cost and risk involved, to determine if it is worth the level of price risk mitigation they are buying.
These derivatives can have a big impact on P&L, unless hedge accounting is used. But hedge accounting carries its own set of compliance issues and challenges. See side-bar “Hedge Accounting and FASB 133 Compliance” for some more details on this. The sourcing person does not need to be the expert in these intricacies, but should learn enough about them to intelligently participate in the decision-making about the best hedging strategy.
Never buy derivatives you don’t understand!
It is important to understand the derivative you are buying, so that you can make sure it is doing the intended job, i.e. intelligently hedging against changes to commodity prices or exchange rates. Companies get into trouble when they trade in derivatives they don’t understand.2
In addition to hedging against commodity price increases, companies may need to hedge against exchange rate fluctuations. Without a hedge, the impact of changes to exchange rates is equivalent to a change in the price of the commodity or component. One approach taken by many companies is natural hedging. The concept is simple. Companies match their revenues made in a particular currency against their costs in that same currency. This way they only have to worry about hedging the difference between revenues vs. costs, since that is their true exposure. The rest is covered by the “natural hedge” inherent in those transactions.3
There are several reasons that companies may want to use natural hedges. Derivatives can be expensive if overused. In addition, complying with FAS 133 can be burdensome (see sidebar “Hedge Accounting and FASB 133 Compliance” above). Just conducting the tests needed to establish the effectiveness of a hedge to comply with FAS 133 can be quite costly and time consuming.4 Natural hedges allow a corporation to reduce their use of derivative contracts, while achieving their risk reduction goals.
The use of natural hedges is enabled by the centralization of treasury operations in multinational firms. Centralized data on inter-company and third-party transactions across the various countries in which a company does business allows the enterprise to understand how transactions in one currency offset those in another, and thereby create natural hedges.
In summary, hedging will become an increasingly important part of the sourcing professional’s set of skills. Hedging is all about balance—not too much, not too little, not too long, not too short. For those kinds of judgment calls, it is best for hedging strategy to be formulated by a cross-functional team that includes treasury, product, and market expertise.
1See http://www.isda.org for more information. The ISDA created these standards in part in response to the debacles in the mid 90s over derivatives bought from Bankers Trust and others by Orange County, P&G and others. Some of those deals were essentially highly leveraged gambles on interest rates.
2Also, buying derivatives for commodities that your company doesn’t actually use is not hedging—that is pure speculation.
3Things are a bit more complicated for the internal financial metrics when there are multiple P&L centers involved—i.e. where one P&L center may be doing all the selling while the other is doing all the buying in that currency—but the natural hedge still works out for the overall corporate P&L.
4FASB's implementation guidelines run several hundred pages!
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