The Hindu Business Line : Hedging to manage price risks

The consumer’s strategy must include determining targeted margins based on cost sheet for each month and fixing cost of raw material as a percentage of total cost of production.

Mr Hemal Shah, Associate Director, Risk Advisory Services, Ernst & Young.

The RBI decision to allow consumers to hedge non-ferrous metals and fuel oil on international exchanges has opened a window of opportunity to several Indian companies that consume them on a large scale, as they can now realign pricing, procurement and inventory strategies and address price risk management, according to Mr Hemal Shah, Associate Director, Risk Advisory Services (RAS), Ernst & Young.

Speaking to Business Line on the dynamics of hedging and how companies can strategise and manage risk more proactively, he said: “The increased volatility in the non-ferrous metal markets in the last few years has clearly illu strated the need for effective pricing mechanisms and hedging tools within the industry.”

Hedging is the process that allows participants to lock in prices and margins in advance before the actual purchase, thus reducing the potential for unanticipated losses. Stating that the volatility of commodity prices has been a major source of instability and uncertainty, especially for the metal consumers, he said that metal consumers in India can now use hedging as a mechanism for metal price risk management.

“There are sustainable benefits of hedging for all metal consumers by way of margin protection, cash flow stability, competitive pricing, etc. What is most important is how we institutionalise it as an important line function within our business activities.”

According to Mr Shah, consumer companies can build risk management capabilities in line with what some leading companies have successfully implemented.

“To be effective, what matters is not size or scale but the approach and rationale you set,” when a company starts this process.

The metal markets have historically been dominated by a number of small players such as mining companies, specialist trading firms and brokers. For copper, aluminium and zinc, the price volatility is approximately 41 per cent, 29 per cent and 44 per cent respectively, according to Bloomberg data of March this year.

Popular tools

There are several instruments that can be used for hedging, but the most popular options are forwards and futures in exchange traded contracts (ETCs) and options and swaps in the over the counter (OTC) market.

Mr Shah said that hedges are very popular with producers, processors, distributors, traders, merchants, investment fund managers and speculators who provide depth in the market.

“On the other hand, manufacturers of cables and wires, auto components, electrical appliances, electrical transformers and transmitters and extrusions form the key consumers. The objective or rationale of using hedging differs for the producer, processor and the consumer.”

According to him, while a producer would hedge to protect minimum floor levels to optimise cash flows, a processor’s objective would be to maximise processing margins.

“For a consumer, the objective would be to minimise input cost by locking target levels. Consumers face challenges regarding pricing of the commodity throughout the value chain.”

Major exchanges

The three major exchanges for trading base metals are the London Metal Exchange (LME), the New York Commodity Exchange (COMEX) and the Shanghai Metal Exchange (SHME). LME records the highest volumes and is the most liquid and popular. The open interest is very high on the exchange; in August 2007 it was 58 lakh tonnes for copper for the current month contract.

“The two major commodity exchanges in India are relatively less liquid and also low on volumes in comparison. For example, the open interest in a domestic exchange for copper in August 2007 for the active month contract was 12,640 tonnes.”

Mr Shah said that with the gradual integration of the global and domestic markets, domestic prices largely track international trends. “Thus, volatility in global markets impacts prices in the domestic market.”

Until April 2007, the RBI did not allow hedging of domestic exposure. But now firms can hedge even if their price risk is solely in the domestic market. “This move will now enable consumers to enter into international markets for price risk management.”

Mr Shah views the advent of the new policy as one that will reduce the dependency of consumers on processors for hedging. However, he added, the consumer also faces certain risks while opting to hedge.

Risks for consumers

“Consumers face inherent risks such as fall in margins in case output pricing and input pricing are on a different basis, shrinkage in margins due to fall in prices during processing period and differential basis in input and output pricing likely to increase losses.”

According to him, these risks can be avoided by entering into long-term supply contracts with fixed pricing, aligning lead time for procurement with production schedules, holding inventory to offset impact of near-term foreseeable movements and undertaking a systematic hedging program to lock-in targeted prices.

“The most critical factors for success of the business model of such a consumer are the ability to maintain positive margins and carry minimum inventory to reduce working capital costs.”

In Mr Shah’s opinion, the consumer’s strategy must include determining targeted margins based on cost sheet for each month and fixing cost of raw material as a percentage of total cost of production.

“It is also important to determine the mix of pricing for each input and output and the basis of mismatch between input and output pricing.”

Then, the consumer must identify the hedge instrument and develop hedging strategies to ensure margin lock-in.

“It is also critical to keep in mind likely customer defaults and delays and then determine the hedge ratios.”

Maximising benefit

For the model to deliver maximum benefit to the consumers, they must enter into hedge contracts based on defined strategies, cancel hedge contracts on or before settlement date and aggregate cash flows from hedges and underlying exposures on the date of settlement.

“Since a consumer would want to know whether this works out as a good strategy, he needs to determine the pre- and post-hedging cost of raw material to review and realign hedging strategies.”

Mr Shah has over 10 years of professional experience. A qualified chartered accountant, he leads the Financial Risk Services (FRS) group of RAS practice, offering financial risk management solutions to banks, corporates and government undertakings.

D. MURALI
C. RAMESH

http://AccountSpeak.blogspot.com

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