One class of risk that has risen as a key issue in the global economy is commodity risk. Because of sometimes large fluctuations in the prices of commodities, a company’s bottom line can greatly be affected. Take, for instance, crude oil prices, which have risen by more than 50 percent over the last seven months.
Role of a Good Hedging Program
The crude oil example delineates the extraordinary level of volatility and uncertainty related with commodities. Many traders erroneously believe that an effective hedging program will spawn cost savings. Rather, the main role of a good hedging system is to control risk and smooth price volatility so that a company can achieve their larger objectives and goals.
Organizations need to perceive their exposure to a specific commodity risk. Primarily, if your profit and loss is liable to fluctuation, based on what’s being bought in commodity markets, this is a vital issue. Your bottom line is at risk.
A good hedging program is unique and should be assessed, based on criteria unique to a specific enterprise, its risk tolerance, and its respective industry. The risk appetite of an airline to jet fuel price unpredictability, maybe vastly different from a bakery exposed to instability of wheat prices. Notwithstanding, what is most essential is comprehending the factors that drive the prices of the commodities.
Moreover, it needs to be noted that a good hedging program does not endeavor to remove all risk. On the contrary, it endeavors to change unacceptable risks into an acceptable form. The objective of hedging program is primarily to allow the organization, to attain the optimal risk profile that evens out the benefits of protection against the costs of hedging.
Building up a Powerful Hedging system
The principal thing that is important to create an extraordinarily effective hedging system is a clear definition of the objectives, with respect to the hedge program. Lack of quantifiable objectives makes it tricky to accurately measure the outcomes from hedging, as successful or unsuccessful.
Secondly, you should contemplate on the following: 1) how much of the commodity exposure to hedge, taking into consideration a foreordained level of flexibility 2) which instruments and markets the company should hold. There are a large range of listed commodity instruments available for companies to employ. Nonetheless, the truth of the matter is that most derivative solutions are built from two essential instruments: forwards and options.
Next comes the execution of hedging strategy. In this stage it is vital, just as in other financial activities, to actualize a system of internal procedures and controls to guarantee that it is used efficiently.
Lastly, you should make sure that hedges are on track. It is critical to revalue the positions, track the Profit and Loss statement, and track the risk, guaranteeing that the hedges stay effective versus the underlying exposure.
Conclusion
Any organization should endeavor to establish a risk management program that allows them to control the uncontrollable. Henceforth, the importance of a good hedging system.