Managing commodity and currency risk

As oil prices rise towards $60, how many oil-importing firms are hedged, and have locked in imports at a lower price, thus laying off commodity and currency risk? In the US, for example, South West Airlines outperformed during oil price shocks because of such a hedging strategy.

Why hedging is incomplete Hedging is often left incomplete, however, for a number of reasons. First, psychological factors undermine rational hedging. People prefer a sure gain, but they also prefer an uncertain outcome with a small probability of gain to a sure loss. In other words, hedging involves a small sure cost, and without it there is a small probability of a large gain. They are, therefore, willing to forgo hedging and undertake more risk than is rational.

Proper ‘framing’ of the hedging proposal, which is sensitive to psychological attitudes, will help. This could emphasise the probability of a large loss, and can reduce risk-taking. In this respect, ‘nudging’ towards hedging from a board-mandated risk strategy and from empowered risk officers can help. Since it is easier to do nothing, the default option should be a stop loss or de facto hedging — selling at a specified price in order to cut losses if market movements generate losses beyond the specified price.

Hedging has an opportunity cost. For example, using futures markets replaces foreign exchange risk by cash-flow risk as margin money varies. So a risk strategy is required.

Earlier, risks were often not quantified and therefore not acted upon. With convergence to International Financial Reporting Standards (IFRS) based on forward-looking fair value, full disclosure of risks would be required (including hedge effectiveness and hedge ratio, or the value of a position covered by the hedge to the size of the position). This would mean marking to market at each balance sheet date. Board and management judgment and perception would have a greater role to play.

Incentives to hedge Administered prices reduce incentives to hedge. Post-reform, these are more market-determined, so volatility can be high. It will no longer be easy to default on debt and to wriggle out of bankruptcy.

Banks can also provide useful incentives. For example, they could link loan rates to risk assessment, and to best practices such as separating business development from marketing. Interest rates that cover expected default under bankruptcy would be lower for a fully hedged firm. Then a firm’s cost of borrowing would be minimised if it is hedged, since bankruptcy risk is lowered.

Other services to corporate treasuries that sensitise them to risks and reduce transaction costs include providing a digital trail. These would effectively use big data that banks generate. Banks can also bring together firms with opposing exposures, since corporate bond markets are thin.

Banks themselves need to lay off customers’ risk. For currency risk they can use exchange traded as well as over-the-counter (OTC) derivatives. Since farmers find margining for futures complex, and largely use commodity exchanges only for price signals, banks could be permitted to also hedge commodity price risks on their agricultural lending portfolios and offer simple OTC derivatives to farmers. But legal changes would be required, for example in the Banking Regulations Act.

The errors made in the 2000 US Commodity Futures Modernization Act should be avoided, however. Among other deregulations, this weakened speculative position limits for banks or ‘swap dealers’ that provide products tracking commodity indexes, such as exchange-traded funds and OTC swaps, for large players such as pension and hedge funds. The aim was partly to attract trade going abroad and partly since OTC dealers (banks) were regarded as well regulated and able to lay off own risk.

As a result, over 2004-08, open interest in oil derivatives more than tripled, and the number of traders doubled. Positions were largely long, and sums involved were very large. Oil prices shot up and then collapsed. There is evidence of short-term bubbles in futures markets where regulation is lax.

The US regulator finally proposed position limits in four energy commodities in 2010, but the EU and a few other markets still do not have them. A 2009 US senate subcommittee suggested a position limit of 5,000 contracts per wheat trader.

The US Dodd-Frank Act banned proprietary trade, but in practice it is difficult to distinguish between own and customer trade. The provision is likely to be diluted. Micro-and macro-prudential regulation is a better alternative.

Position limits Speculation involves betting on an expected one-way price movement, and needs to be restricted. But regulatory authorities tend to put restrictions on participants and on derivative products in order to curb speculation. More and large participants, such as institutional investors, however, create liquidity, and derivatives add instruments for hedging. So instead of restrictions, contracts can be designed to encourage hedging over speculation. Differential margins and discounts in fees or taxes for each category can distinguish between hedgers and speculators. Margins that increase with price could reduce momentum trading. Position limits can reduce the share of speculative transactions.

In India client position limits are too low, however, and could safely increase along with more institutional investor entry to create liquidity. Integration of spot markets and negotiable warehouse receipts are also required to get nationwide rates for agricultural commodities and link futures with the spot market. More instruments such as index trading and options will allow design of flexible hedging strategies.

Commodities are often imported or priced abroad, and therefore also involve currency risk. Hedging commodity risk requires hedging currency risk. The Reserve Bank of India had imposed curbs in currency futures trading by banks, including a ban on proprietary trading. As a result domestic markets stagnated while offshore markets grew. Bans were lifted in June 2014, however. Position limits for banks were set at 15 per cent of total open interest or $100 million, whichever is higher, on each exchange. But domestic markets need to deepen more.

Further reform to allow cross margining and economising on collateral, could increase efficiency of hedging strategies, and reduce cost. Clearing clusters could develop for commodity and currency risk.

The writer is a professor of economics at Indira Gandhi Institute of Development Research, Mumbai.

This article is based on comments made at a panel discussion organised by CAFRAL and MCX on December 15, 2016

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