Understand Your 'Real Risk'
How much of your exposure can you mitigate or offset, by ‘natural’ hedging, or other means; based on your Business Flow as well a Cash Flow, helps determine your Hedge Profile.
Know Your Parameters
This relates to the analytics of your ‘Real Risk’. Create your hedge range. Determine what percentage of cash flow to protect and the rationale behind this, and a range of coverage — and ‘institutionalize’ this process, to bring consistency to your risk management — including a review and evaluation process.
Know When A ‘Flawed’ Hedge Is Best, And When It’s Worst
Some structures have their time and place. For example, a forward has equal protection and equal risk. At market tops and bottoms — if you’re aware of them, this structure can lock in 100% protection. There are many examples of this with airlines hedging jet fuel. But use forwards exclusively, and your company can rack up major losses — again, just like airlines — losing billions of dollars over the past few years.
— Ryan Air hedged 2020 fuel at $83. Estimated losses of USD 1.5 billion.
— Easyjet, similarly, has a projected loss of USD 1.3 billion in 2020.
— Airfrance KLM lost an estimated USD 800 million this year.
— Southwest airlines hedged 59% of its 2020 fuel consumption at $88.20 per barrel, with similar losses projected.
Be Aware Of ‘Proxy’ Hedges
Proxy hedges are ‘indirect’ hedges, because there is no established market exchange for your specific product. For example, in paint manufacturing, approximately as much as 30% of paint may be solvent based — petroleum distillates.
Whereas there is no efficient way to hedge hydrocarbons — Benzene, toluene, xylene and others, using crude or refined oil contracts as a proxy hedge to approximate your market risk exposure can be an effective substitute — if researched and evaluated correctly.
Banks — your hedge counterparties — are not your pals
A Bank’s job is to make money off a client in the most ‘efficient’ way. (Read: easiest, riskless, most convenient, most profitable. Just think of credit cards at almost 20% interest.)
They don’t create a strategy for hedging. They don’t manage your hedges. They are not advisors. They are not your ‘team’. They probably don’t even ‘like’ you, though they may smile a lot.
Never forget they are sales persons and product pushers — just pick a product and buy it — without too much time and trouble. And don’t expect them to teach you anything. The most you’ll get are a few short blurbs here and there — and probably some impatience and discreet frowns.
Do Your Homework — Do The Grunt Work
Yes. Hedging is not your core business. But it can greatly impact cash flow and prevent volatility from destroying your profitability. So get a handle on it. What does this mean?
— Learn the Bank Products. The two core products — Forwards and Zero-cost Collars — and their varied and many iterations. Understand the risks and costs of each product and Bank offering — taking it a step further, if possible*.
Create Your Hedging Infrastructure
Energy, currency and commodities are risk areas for those corporations exposed to them, that require additional attention and management, apart from usual corporate risk management committees.
Since effective management means dynamic intervention, at times, a treasury department has to address these markets.
Whether you have your own in-house team — which may or may not have the requisite skills and experience, or outsource this function — which also may or may not have the requisite skills and experience, senior management must reach a certain level of hedge risk knowledge.
Cash flow protection can’t be solely in the hands of a team-head ‘expert’ without some sort of check on this decision maker.
There are no rules or formulas which will (completely) or reasonably protect your cash flow over time — save one.
Don’t measure hedge success by a quarter or a year. It’s an ongoing never-ending challenge. When the market ‘fits’ your hedge, don’t think you’re great; and when a financial tsunami hits, don’t think you’re a fool.
It’s survivability that’s the thing especially over the long haul. And that’s what hedging is — a never-ending long haul — just like your business. So the all encompassing law of survivability is:
Never complacent, always diligent, continually flexible.
Treat Hedging As An Adjunct Profit Center
Of course hedging is not speculating, but successful cash-flow management supplements profitability. So it deserves a strong corporate emphasis.
How much effort and expense would a company expend to increase profits 10%-15% a year. Place this same emphasis on hedging. Some years actually bring such market gains, or more, and significantly boost the bottom line. Other years, effective hedging will hold the line on losses and profit declines. One way or another, your hedging program can create a positive impact.
Don’t Be Overwhelmed By Hedging
By making hedging a process and standardizing it, the difficult and confusing becomes normal.
By following your established procedures and holding onto this framework, cash flow risk management is achievable and sustainable.
If you believe in your approach — through all markets — not just your ‘successful’ ones — the process becomes a mission statement.
