Hedging Transactions

Hedging activities are increasingly important for modern business.  Stability of revenues, forcastibility of cashflows and predictable returns are good for majority of businesses (except for companies where risk taking is part of its core activity).

Hedging and derivatives transactions have often in the press been associated with losses and risk taking, yet this is the problem of the press not of hedging instruments, as in their search for any "sensational topic" bringing out the losses is a popular topic, even though vast majority of companies are using hedging for the right reasons to provide stability to their business models, financials and work force.

Various financial instruments have various characteristics.  While most bonds offer fixed rate coupons, loans will offer floating rate coupons.  Even on the floating rate, 1m Libor can be significantly different to 12m Libor.  For large transactions local companies often have to engage loans that are denominated in foreign currency, meaning that the company naturally takes on FX risks.

These risks can be hedged against, enabling the company to either link its interest repayments to the market conditions, or depending on the activity to the other assets (utilities often are able to pay inflation rate as their revenues are by regulations protected against inflation).

In addition even the principal can be linked to the elements such as commodity pricing, where the company that is producing a commodity repays less if the value of its produce has decreased, hence protecting the company from adverse changes to the market conditions, and ensuring that it has needed stability.

Cashflow Hedging

In the increasingly international world, companies become global.  Import and Export its at its peak, raising in 2010 by 9,5% alone, and reaching 25% of the world GDP.   This means that every 4th product or service produced is being exported.

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In addition with the increased lack of stability of the financial markets, significant fx moves and incrasing uncertainty, together with the generally reduced margins, it has never been more important to apply hedging then today.

Hedging today is not only to protect the profits, but it is predominantly to ensure that the company has stability in its business operation, revenues, costs.   Importers  hedge to ensure that their prices are stable, so that they do not have to change their prices, often requiring reprinting of brochures and other offer documents.  Exporters need to ensure that their remain internationally competitive, yet it is not reasonable for them to be expected to amend their costs, including wages and investments as soon as there is a change in fx rate. This is especially important for companies that deal with commodities.

However there is much more to good hedging policy than identification of risks.  To carry out hedging correctly, companies need to understand that while they can protect themselves from the short term currency swings, in the long term many of the fx changes will remain, and companies must adapt themselves to the new reality (cut costs, change production process, renegotiate contracts).  When conducting hedging activity it is hence particularly important to identify how long such changes would take place, elasticity of the markets and flexibility of the wages.  Only by conducing a good analysis the company is able to then have a fully coordinated hedging policy with its business.

Commodities Hedging

Number of commodity companies chose not to hedge as they believe that the shareholders invest in them predominantly in order to have the exposure to the underlying commodity.  This is correct.

There are however four principal elements where even the riskiest of the investors will usually encourage the commodity companies to hedge:

1) hedging in the event when the cost of product is approaching its cost of production, threatening the firm to start to lose money and potentially go out of business.  In such cases we have seen a sudden significant increase in the demand for hedging products, as miners and oil companies hedge their revenues in order to give themselves time to amend their business models, and potentially to wait for number of their competitors to go bancrupt, hence causing the reversal of the price trend (via reduced supply).  In addition hedged business means greater stability to the finances, to the cost of borrowing curve, refinancing possibilities.

2) short term hedging designed to protect the salaries at the domestic location, contracted out investment projects and expansion plans, ie parts of the income statement that are not passed on as profits to the shareholders.  Vast majority of airlines apply commodity hedging, as it would be almost impossible to change the ticket pricing policy on the daily basis, especially as vast majority of tickets are actually sold prior to the service of the flight being provided.

3) Project Finance, some long term investments will be calculated using some predefined profitability levels, and sell price. Some companies chose to sell out their produce for years to come at predetermined prices (coal mines that supply local power plants for instance), hence ensuring that they have certain cash flows enabling them to concentrate their efforts on business operations and management of efficiencies.  Number of refining companies that borrrow money for modernisation and new equipment, do so with the assumptions of being able to obtain some refining margins, which they tend to hedge for the duration of the finanicng.

4) Hedging of liabilities.  Contrary to number of assets that are almost perpetual in their nature, liabilities can be fairly short dated.  It is hence often very important to be able to link the value of the liabilities to that of the production, so that in the event of the significant deterioration of market conditions, the company is able to repay its obligations, potentially keeping its leverage ratio constant.

5) Client driven hedging is an area of constant growth.  Number of companies, oil refineries, miners, commodity processing plants, are asked by their clients to provide them with the fixed term products at the fixed term prices.     These have numerous benefits, starting with the ability to obtain a higher price for such products, to the accounting treatment benefits, as such contracts made with the supplier wound not be treated as hedging contracts and hence required to be mark-to-marketed (what in turns can offer especially smaller companies a significant volatility).  Number of utility companies are for instance providing fixed term prices for their electricity and gas products, enabling themselves to lock in higher margins (especially if the pricing is in backwardation), but also making the service that is demanded by the clients.

Risk Optimisation and Hedging Policies

Vision Finance has developed its own proprietary tools aimed at providing corporates with correct analysis of their risks, and exposures.                                                                                                                                                                               

Our model is paramount to the designing and establishment of the right hedging policy.