Published: October 01, 2009
An active financial risk management process is necessary, to answer the following questions:
Only when these analyses have been made and the links clearly understood is it recommended to evaluate risk strategies and make use of derivative instruments.
This is where the experience of the treasury division is of benefit to the purchasing function. Long before there was much discussion of high volatility and unpredictable price fluctuations this was a common scenario for the treasurer. For years, treasurers have been tackling the problems of interest and exchange rates in an analytical and structured manner, in order to get to grips with the effect on overall profits and interest expenditure.
For years treasurers have been tackling the problems of interest and exchange rates in an analytical and structured manner.
The company buys around 3,000 tonnes of aluminium alloys a year. Given the situation as of January 2009, one tonne of aluminium is priced at a record low of USD 1.150 on the LME. The total purchase volumes based on the current market price currently amount to USD 3.5m.
The historical volatility is around 45% and the peak is USD 2.860.
Based on this peak, the company is exposed to a price movement risk of USD 1.700 per tonne or a total of USD 5.1m.
Accordingly, the price opportunity on the basis of the record low in 1997 of USD 1.000 is relatively small at USD 150 around per tonne or around USD 500,000.
In addition to the market price risk, raw materials prices have a significant effect on production costs.
InterpretationIn table 1, the average costs of raw materials influence the production costs at a rate of around 50%. The raw materials costs again account for around 80% of the materials costs. The proportion accounted for by aluminium is about 20% of materials’ costs and consequently a notable factor in comparison with the company’s total production costs.
If the costs for aluminium, for example, rise by just 10% then
A productivity increase of 0.8% (EUR 800,000) would be needed in order to neutralise this 10% rise in costs. As it is not always possible for a processor of aluminium components to achieve this in the short term, no additional explanation is needed.
In this respect, time can be saved through a good hedging strategy to make and implement the necessary adjustments in order to maintain or expand the competitive position.
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The company buys aluminium components with an aluminium alloy content of L226. The price is ascertained on the basis of Wirtschaftsvereinigung Metalle (WVM) publications.
This low-fusing alloy is not of a quality that can be traded in standard contracts on the London Metal Exchange (LME).
The following standard contracts are traded on the LME:
In comparison with aluminium alloy contracts, the HG market shows a considerably higher liquidity. The trading volume is approximately 100 times higher than for alloy contracts. Option models can be depicted simply and are standard rather than an exception on the alloy market.
This pre-supposes that an examination is made of which market is suited to a price security strategy for the company’s aluminium price risk.
The longer-term chart analysis on a daily basis (source: internal records based on LME data) demonstrates that the markets for high grade aluminium and aluminium alloy have essentially had a parallel movement in terms of price trends but that the fluctuations on the pure aluminium market are much higher. Among other things, this has to do with the lower degree of liquidity of the market and the fact that the contracts are also used for capital investments.
On the other hand, the graphs also clearly demonstrate the currency risk to which aluminium processing companies are exposed in EUR in both a positive and negative manner as the LME trades exclusively in USD.
The price rises were slightly less dramatic for EUR processing companies as the USD lost a considerable amount of its value, particularly in 2007 and 2008.
[[[PAGE]]]The visual long-term comparison of the purchase prices with the LME listings of the market prices over a monthly average identifies initial doubts as to whether the pure aluminium market is a suitable basis for a hedging strategy of the materials price risk.
It is clear that the LME prices for pure aluminium are noticeably more volatile and show considerable price swings whilst aluminium alloy prices seem to follow a steadier course.
A visual comparison shows at a second stage the correlation between the price time series. This is to do with the exchange rate relationship between two values – here the price time series comparison of the purchase price with the corresponding LME prices.
The straightforward price correlation shows that there is a considerably higher correlation with the purchase price for aluminium alloy. However, it is doubtful whether price hedging can produce the desired success based on this relatively small correlation of less than 0.8.
The simple price correlation, however, is only meaningful to a limited extent because it merely expresses that, for example, the L226 price has moved in a specific proportion to the market price in the past.
The coefficient of determination (see Table 3) should provide information on the extent to which the changes in prices on the LME for HG aluminium and aluminium alloy can be explained.
The result of the analysis is initially bleak and provokes the comment: “Hands off hedging”. The coefficient of determination shows that in only 36% of the cases can the price changes be explained by movements on the aluminium alloy market.
However, there is still a question as to whether the correlation based on monthly price changes is actually suitable, because the company’s price change risk for production costs is in fact in a range of between 12-18 months: but the market deals in fixed price lists and price increases based on the rise in the price of raw materials can only be achieved 1) with considerable difficulty and 2) with a clear time offset.
The correlation analyses in Table 4 should provide information as to whether and to what extent a parallel development can be proved over longer intervals which would justify the hedging of raw materials prices.
Table 4 shows clearly that the visual impression gained from the long-term chart analysis is confirmed. In the short term, it may be that the price curves show varying developments and in the long term hedging using an aluminium alloy offers the required effects of price stability.
Price hedging through the aluminium HG market is not, however, recommended.
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In order to further support or check this statement, a regression analysis was conducted. In this, the linear link - as was the case with the correlation analysis between both time series - can be depicted in a quantified and visual manner.
A hedging strategy and the expectation of the highest possible compensation on the purchase effects are not really possible on a monthly basis.
In addition, primarily the regression rate and the deviation of the individual points are of significance to the scale of the link. The rise of the regression rate depicts the link between the movements in the independent variable (LME price) and those of the dependent variable (purchase price).
Diagram 1 depicts the movements in the aluminium alloy prices on a monthly basis and Diagram 2 shows how the changes in the aluminium prices on the LME are eroded over a period of 12 months.
To conclude, this graph shows that the changes in LME prices for aluminium alloy will have an effect of a factor of 0.91 on the purchase prices – if the prices on the LME rise by EUR 1 per kilo, the purchase price rises by EUR 0.91 per kilo. Furthermore it can be seen that over 84% of the changes in purchase prices can be explained by this.
As the above analyses show, a hedging strategy and the expectation of the highest possible compensation on the purchase effects are not really plausible on a monthly basis.
The correlation over three months is relatively low at 0.7 and the coefficient of determination is just 0.6 which shows that in 60% of cases the purchase price follows the market price but does not in 40% of cases.
The correlation does, however, considerably improve if longer time scales are applied.
This comes mainly down to the expectation and objective of the hedging as regards the financial risk management strategy followed.
If there is an expectation of a high compensation of the price change risk of the raw material purchases, the answer is categorically no and price hedging is not recommended.
If the expectation is to receive additional coverage in relation to the budgeted raw material price, then the hedging of the financial risk is clearly recommended.
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