Global financial turmoil and shifts in the market have resulted in incredible price volatility for the commodities businesses buy and sell. This volatility can significantly impact a firm’s profitability. Many businesses are starting to use hedging to protect themselves against volatility and the threat these price swings pose to business’ finances. Here is how implementing financial hedging can affect your business model.
Risk Reduction
Hedging can protect a business from the potential problems of rising interest rates and associated debt payments. If there is a high probability of a cash shortfall, such as challenges paying debt obligations or capital expenditures, then it is worth hedging one’s risk.
You should hedge based on your net economic exposure, not the risks one business division is concerned about. If your business is engaged in international trade, you could hedge the company against currency fluctuations. This means taking into account both what your firm buys in that currency and sells in that currency, and then planning for the overall risk to the company.
Commodity options protect your business from lower prices while giving you the ability to profit from higher prices. However, hedging needs to consider not only protection from potential losses as commodity prices fall but the potential upside if prices go up. Hedging can be costly, and not enough managers understand the cost-benefit ratio of the contracts they enter. Don’t enter a hedging contract that costs more than the risk it mitigates.
Managers may make decisions based on an assessment of the cash flow in a given situation but fail to consider the odds of the scenario that is almost certain not to happen. Sometimes they fail to consider the company’s ability to absorb those losses if they did come to pass. Don’t assume that hedging is the first or best way to manage risk for your business. Perhaps shutting down facilities when operating costs are too high or altering product specifications is a better choice. Alternatively, a business could look at cost savings like integrating the business vertically. Furthermore, businesses could mitigate the risk by setting aside larger cash reserves to cover potential losses. Understand all of your alternatives and pick the one right for your situation.
Increased Opportunities
Hedging strategies can protect you from rising interest rates but allow you to benefit from falling interest rates. An interest rate swap would let you lock in current interest rates. An interest rate swap creates a synthetic cap on interest rates the business pays. More complex hedging products can give you the option to enter a swap that alters your interest rate without the obligation or provide the protection of a fixed rate with a high degree of flexibility. In all these cases, the business benefits from protection from higher interest rates and debt payments while having the opportunity to exploit lower interest rates.
Foreign currency exchange hedging can protect you from wild swings in currency valuations while allowing you to benefit from favourable changes in a currency. Read the financial hedging products explanation from JCRA to better understand your options for managing risk while maintaining the ability to profit from favourable changes in the market.
Protection for the Business
Hedging can be used to ensure that you receive at least a certain price for a product or don’t pay more than you can afford for critical materials. Commodity call options protect you from higher prices for key commodities but let you benefit from lower prices. Only hedge what matters. For example, an aluminium manufacturer should hedge their exposure to aluminium since price fluctuations in the price of aluminium have a significant impact on business’ bottom line. That business shouldn’t worry about hedging against oil and gas prices because it has very little impact on their overall margins. It is a waste of money to hedge risks that don’t pose much of a risk to the company.
If your current contracts are already structured to minimise the company’s exposure to a commodity’s price, hedging becomes a costly redundancy. In the worst-case scenario, hedging increases the company’s financial sensitivity to commodity price fluctuations to which it was previously immune.
Conclusion
Hedging is one way to protect a business from prices in the materials they buy and products they sell, and it can be used to minimise the impact of changes in a currency’s valuation. It is essential for businesses to understand what they are doing, in order to avoid costly mistakes.
