Risk management guards against or eliminates potential cost increases while securing profit margins and sales. Hedging is part of risk management, but risk management is a process that, implemented wisely, adds quantitative and qualitative value to your business. "Hedging" and "risk management" are often used interchangeably. The problem that causes is not just a lack of understanding of risk management. It's that risk management gets a bad rap because hedging has a bad rap. Hedging has a bad rap because a few unqualified and careless individuals have hedged or overseen hedging activities and caused unnecessary and unexpected losses. Neither risk management nor hedging deserves a bad rap; that's like blaming cars for accidents caused by drunk drivers.
With that introduction, if I worked for a processor who wanted to control resins prices, and increase sales and secure profit margins, I would follow this roadmap:
These are strategic and bottom-line objectives, such as:
- Meet or beat budget or other profit margin expectations
- Mitigate or eliminate price risk in purchases and sales
- Secure and increase revenues
Write a Risk Management Policy
This step is critical but most often overlooked or bypassed. The RMP establishes responsibilities and authorization levels, hedging procedures, approved tools and strategies, hedge accounts and funding, reporting requirements, etc. to achieve the Objectives. At a minimum, the final RMP should have CFO signature approval.
A good RMP is well worth the time and effort. For example, it requires that hedges be analyzed correctly; i.e. not analyzed separate from the underlying physical positions they were designed to protect. Unfortunately, CFOs who aren't involved in developing the RMP oftentimes define hedges as 'good' or 'bad' depending on whether or not they made money. Hedges can and often do make money, but their purpose is to mitigate risk and help achieve the Objectives. They are not trading positions to be analyzed on their own, and if your CFO doesn't understand the difference, you should not open a hedge position until he does understand or at least signs off on the RMP.
The RMP may only be a few pages long, but ensures coordinated and successful implementation of risk management - and, therefore, hedging - activities. (See also Hedging Rules in Price Wise, May 31, 2011.)
Implement the RMP
Designate an experienced and trustworthy individual as Risk Manager. The risk manager's responsibility is to implement the RMP. The most challenging part of implementation is getting things up and running smoothly. If someone in your organization doesn't meet the qualifications, hire a risk manager for initial implementation and train an in-house candidate to take his or her place after an interim period. Once it's up and running, you'll be pleased with how easy and beneficial risk management is ... like riding a bike.
Next time: RMP specifics, including hedging strategies
About the author: Tom Langan of WTL Trading is a risk management consultant helping processors and suppliers control commodities costs, increase revenues, and secure and improve profit margins.