Developing a hedging strategy starts with understanding risk

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Countless factors can affect an organization’s position and risk tolerance. Before developing a hedging strategy, understand the significant areas of risk and the tools available to manage them.
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Hedging is fundamentally a protective strategy reflecting a company’s attitude toward risk. Companies can hedge to manage risk in critical business areas, such as commodities, foreign exchange, and interest rates. Volatility or unpredictability in any of these areas could be disastrous to a company and hedging strategies can be used in a variety of ways to help protect against those uncertainties.

“There’s no exact science to developing a hedging strategy. It all depends on your risk tolerance and disposition.”

Lawrence Heath
Senior Managing Director of Derivatives, Huntington Bank

Countless factors can affect how companies handle their exposures. Organizations need to start by internally analyzing their risk, but they might not always understand or have full visibility into these risks. After all, economic activity, market shifts, and rate changes can all affect a company’s position. Before developing a hedging strategy, it’s helpful to understand the three main areas of risk and the tools available to manage them.

1. Foreign exchange

Foreign exchange is a common area in financial risk management. Companies working in one currency (U.S. dollars, for example) and transacting business with companies operating in another currency (such as euros) are exposed to transactional risk. As the dollar strengthens or weakens compared to the euro, it can erode the value of foreign sales or increase costs associated with a foreign transaction.

Foreign currency hedging can include locking in a forward rate or options contract, which allows a company to protect its U.S. dollar equivalent cost or revenue when settling contracts in the future. With foreign exchange forwards, companies agree to a future exchange rate to offset the underlying exposure. Options also protect the company at a specific exchange rate in the future while allowing for participation in favorable foreign exchange movements for a small upfront fee. A combination of these strategies will enable companies to adjust budget rates for the coming year based on market dynamics.

Currency risk advisors can help a company quantify its exposure in foreign transactions and then come up with a plan to mitigate unwanted risks. From there, they can explore specific hedging instruments and strategies to help them stay within their defined risk parameters while still meeting strategic goals.

“Customers may have a degree of certainty in their foreign transactions,” explains Gabe Gigliello, Senior Managing Director of Currency Risk Management. “We can hedge the shorter-dated, more certain exposures using forward rate agreements and then use an option strategy for the longer-dated, less certain exposures. Then, readjust on a periodic basis.”

2. Commodities

In commodity hedging, the type of exposure drives the strategy. Hedging metals, for example, can be a short-dated inventory hedge or a longer-dated cost exposure hedge. An inventory hedge is typically no longer than three to six months. Companies purchase the raw material and manufacture it, then ship the resulting product to customers. It’s a short-term inventory risk that companies want to manage through short-dated hedging. A more strategic cost structure that hedges out 12 to 18 months will fix a cost price for a more extended period.

On the other hand, hedging strategies in the energy space might be as long as one to three years out. Conversations about hedging in this area involve companies getting a handle on their budget for fuel or natural gas costs through an extended period. There are several hedging options in these situations. Companies might choose to hedge around their budgeting period or develop a more disciplined strategy based on a strategic time frame. Sometimes, commodity hedging is jumpstarted not by a strategy in place but by a price swing. A dip in the market or a price shock for a commodity of interest might trigger a hedge.

Reducing commodity price risk comes from decoupling the physical commodity from its price risk through a financial hedge to reach a settlement that sets a stable price. Commodities are purchased at a locked-in rate over a defined period, and gains or losses are realized at the end of each month based on the commodity index. If the price climbs higher than the set rate, the company receives a settlement.

Companies should speak with their relationship manager and commodities desk to understand their exposure in the markets and where they might be able to hedge naturally. For instance, some might have a surcharge payable by users of a commodity. The company could pass on an increase in commodity price to their customers.

“Most of the work in a commodity hedging program involves understanding your exposure and its impact on your company, whether in terms of Cost of Goods Sold (COGS) or even up to variance in earnings per share,” says Darrell Fletcher, Senior Managing Director of Commodities at Huntington. “Commodity volatility is high. Taking charge of the costs that can be controlled will have a strong impact on a company.”

3. Interest rates

Interest rate risk is tied to a company’s variable long-term debt and the current rate environment. Volatile interest rates can present a risk to companies that haven’t locked in rates on their debt. This is where interest rate hedging strategies come into play.

There are a variety of approaches to managing or eliminating interest rate risk. Common risk mitigation tools include interest rate swaps or a traditional fixed-rate loan. While a mixture of fixed- and floating-rate debt can make sense for some companies, every situation is different.

For example, since there’s no financial benefit to a fixed loan if rates decrease, some companies might choose an interest rate swap to set how much floating exposure it wants. That decision will determine when to start hedging and for how long. On the other hand, some companies have such a tight cash flow they can’t take the chance that rates will increase, so they opt to fix their rates and take the unknown out of the equation.

Risk management strategies must be based on each company’s unique situation and tolerance level. The first step is understanding how interest rates affect the company and how much risk they’re willing to take. From there, companies can structure an approach that manages that exposure while staying within a comfortable risk zone.

As the economy shifts, so do rate and risk environments. Interest rate exposure management, whether through an interest rate swap or traditional fixed-rate loan, protects against future uncertainty to allow companies to focus on day-to-day operations.

“The goal of hedging is to control your identified risk and allow time to focus on your underlying business. Regardless of market movement, you can achieve the goal you set out with,” explains Heath.

Protect your margin

Which hedging strategies a company chooses is determined by what they’re trying to achieve. The Huntington Capital Markets financial risk management team can help a company identify its exposure, develop a plan to manage its risk, and determine the risk management products that fit its strategic goals.

“You need to have a strategy and stick with it. There will be times when hedging would not have been beneficial, times where it was critical, and other times where it isn’t going to matter,” says Heath. “It’s short-sighted to believe it’s always going to work out in your favor or think it’s not worth it in the short term.”

After setting a company’s overall risk tolerance policy, stay true to it to help bring certainty to the business.

“If you’re hedging and you’re protecting your margins, that's your job as a treasurer or CFO,” Heath says. “You’re not here to speculate. It’s hard not to look at and follow the market, but that’s what you have to do. Instead, stay true to your overall purpose of hedging.”

Every company’s risk tolerance and exposure are different. To learn how hedging strategies could help you manage risk through dynamic market changes, contact your relationship manager or visit huntington.com/Commercial/capital-markets/protect-capital.

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