The Hindu Business Line : Commodity price risks: To hedge or not to hedge

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Commodity price risks: To hedge or not to hedge

T. B. Kapali

WITH NEW REGULATIONS companies can now hedge economic exposures right through the operating cycle.

One of the key inflation-fighting tools used by the Government in recent times has been import liberalisation. To ease the domestic prices of many commodities — both for intermediate and final consumption — the Government has moved on many fronts to bring down the landed cost of imports. One is not sure if the measures to raise the level of import competition vis-à-vis domestically produced goods have had an enduring impact on local price levels. That is an on-going process, the results of which will only be known over time.

Domestic Transactions

It appears, however, that companies in the commodities space need not worry too much about the pricing power dilution that import competition can create. For, another (extended) arm of the Government has moved almost in tandem with the Government's own actions on import liberalisation to enable Indian companies with commodities exposures to better hedge their price risks.

The Reserve Bank of India recently permitted commodity hedging, even for domestic transactions. That is, domestic producers and users of certain select commodities can now hedge the price risk on their domestic sales/purchases through international commodity exchanges such as the London Metal Exchange. Previously, such hedging of the price risk on domestic sale/purchase was not permitted, even if the domestic prices were linked to international commodity prices.

A Hindalco, for example, can now hedge the economic exposure it may be running on its operations (on account of import competition), by undertaking hedging through international commodity derivative exchanges. Previously, the company's access to the global commodities exchanges was restricted to the level of its imports/exports.

While the company's revenue exposures — both export earnings and raw material import payments — in foreign exchange are quite considerable, at around 25-30 per cent of its total income, and provide a natural hedge, that hedge was more against the risk of foreign exchange fluctuations affecting operating results.

The price risk on the commodity being imported/exported was, of course, permitted for hedging but timing differences between the company's imports and exports meant that optimal hedging solutions were still not in place. For instance, if commodity prices were high at the time of imports but finished goods prices softened at the time of exports, the company would be affected despite the price risk being individually hedged at the time of imports/exports.

Still Some Way To Go...

The RBI's latest move permitting hedging even for domestic transactions is significant in that it expands the breadth and depth of the hedging mechanisms available to a company. In effect, a company will now be able to hedge its economic exposures right through its operating cycle, covering not only its regular imports and exports, but also its more important domestic sales and purchases. Active operations on the hedging front may, in course of time, become fairly routine in Indian companies with high commodities exposures.

While there has been a big leap in terms of the flexibility of hedging alternatives now available, in terms of hedging against economic exposures, we have yet a long way to go.

Small-scale and medium-scale exporters, for example, are facing tough times now on account of the rapid appreciation in the rupee. This is another example of economic exposure the Indian exporter faces; while the rupee has gone up sharply against the common currency (the US dollar), the currency of the competitor country(ies) has not appreciated in equal measure. It may not be possible to hedge against this risk only through the foreign exchange market. A wider range of hedging alternatives — including those through the commodity exchanges — may help. Indian textile exporters, for instance, may be permitted to hedge their domestic purchases of cotton through the global commodity exchanges, which provide greater depth and liquidity.

May Not Always Help

While developments at the macro level are welcome, the micro-level implications are not uniformly favourable. For instance, if hedging is not an accepted practice or the norm in a particular industry, it may not be advisable for one company in a sector to depart from industry practice.

If final product prices in an industry fluctuate to reflect the impact of changing raw material prices, all companies in the sector will be sailing in the same boat, by either hedging or not hedging, all together. If one company were to depart and have a standing policy on hedging raw material price exposures while its counterparts do not, it may well experience greater variability in its margins/earnings.

That is because the impact of the hedging in economic terms — that is, profit or loss made on the hedged position — would go to either inflate or deflate the final margins, given that the product price has already moved to reflect the changed raw material prices, interest rates/exchange rates or whatever.

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