Risk Management

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Commodity and FX Risk Management – An Integrated Approach Nothing focuses attention on an organisation’s financial risk management capabilities like a bout of sustained market volatility. When financial markets destabilise, as we saw in 2008 and 2009, risks that may once have been seen as a low priority by many organisations, suddenly become much more visible. Both foreign exchange and commodity prices have witnessed dramatic increases in market volatility since 2007, creating an increased requirement for corporate treasurers to ensure that these risks are being effectively managed. In this article, Kevin Lester and Alexander Haigh examine the importance and benefits of an integrated approach to commodity and FX risk management, look at commodity price volatility, liquidity and basis risk, and the many other factors that must be taken into account in order to successfully manage the risk of both.

Commodity and FX Risk Management – An Integrated Approach

by Kevin Lester, Director of Risk Management and Treasury Services, and Alexander Haigh, Financial Risk Management Consultant, Validus Risk Management

Nothing focuses attention on an organisation’s financial risk management capabilities like a bout of sustained market volatility. When financial markets destabilise, as we saw in 2008 and 2009, risks that may once have been seen as a low priority by many organisations, suddenly become much more visible. Both foreign exchange and commodity prices have witnessed dramatic increases in market volatility since 2007 (see chart 1 below), creating an increased requirement for corporate treasurers to ensure that these risks are being effectively managed. 

A recent study by Accenture[1], the international management consulting firm, revealed that 35% of corporate executives surveyed believe that commodity price fluctuations have the potential to cause the greatest increase in risk to their firms (a significantly higher percentage than those who listed other factors such as decreased credit availability and liquidity risk). As a result of this focus, many corporate treasurers have become more concerned with ensuring that firm-wide financial risk is managed efficiently and effectively, incorporating commodity risk management into their current treasury risk management strategy. For those corporate treasurers already used to managing FX and interest rate risk, this has led to a focus on a more integrated financial risk management strategy. This type of strategy considers both the unique characteristics of commodity markets themselves, as well as the complex relationship between FX and commodity price risks that must be considered when implementing a robust hedging strategy.

The importance of an integrated approach

Traditionally, FX and commodity price risks have been managed independently within many organisations. There are a number of reasons for this segregation, perhaps the most important of which is the fact that responsibility for commodity risk management is often located in a different part of the organisation (e.g., the purchasing department) from FX risk management. Even when corporate treasury is responsible for both FX and commodity price risk management, this does not necessarily lead to an integrated approach that is based upon a holistic view of financial risk. Such an approach should take into account both the direct (causal) and indirect (correlational) relationships present between a company’s commodity and FX exposures.

A direct relationship between FX exposure and commodity price exposure occurs when a commodity price is determined in a currency other than the functional currency of the organisation (clearly, as most commodities are priced in USD, this is a common issue for non-USD functional organisations). In this situation, the commodity price clearly drives the currency exposure, and the size of the notional FX exposure rises and falls as a direct result of commodity price fluctuations. For example, take a Canadian lumber exporter, selling into the US market. If the organisation determines its USD hedging requirement based on expected sales volume only, without hedging the underlying lumber exposure, movements in the spot lumber price could easily cause inefficiency in the FX hedging programme. An integrated approach to risk management, where the currency hedging programme is closely linked to the decision to hedge (or not to hedge) the commodity risk is therefore critical, in order to ensure the organisation does not run into severe over or under-hedging situations. In many organisations, this relationship is ignored (due to a separation of responsibilities) leading to considerable hedging inefficiencies. If hedging the underlying commodity is not possible (due to limited forward market liquidity, for example) or desirable, the currency hedging should reflect this through increased use of optionality or carefully calibrated hedge ratios.

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