From fluctuations in oil and commodity prices to geopolitical conflict and emerging markets, today’s organizations must operate in an ever-shifting global landscape. In the face of such uncontrollable external risks that threaten their companies’ strategy and performance, CFOs are increasingly turning to hedging principles for protection.
William Watts
Without proper management, however, hedging can lead to risks of its own. That’s why hedging-oversight committees across industries are gaining traction.
CFOs typically view hedging as a strategy to mitigate their risks from uncontrollable changes in the market. More specifically, a CFO might employ hedging as a means to:
Currency risk is often a particularly significant concern for companies that pursue hedging. An organization entering a sales contract might be comfortable with the expected margin, only to see that margin slip away because exchange rates have dropped dramatically and unexpectedly. Hedging lets a company avoid such risk by locking into a certain amount of profit on the sale.
The major pitfall in hedging is not knowing what you don’t know. Many times, the decision-makers involved in hedging are unaware of certain aspects of their business’ operations, which makes it difficult to choose the right hedge or approach to mitigate the risk. An executive might have the best intentions and reach a decision that makes perfect sense for his or her sliver of the organization — but actually ends up adding more risk exposure in the context of the entire company.
For example, a company that sells its products around the world receives a contract to sell one billion yen worth of goods over the next year to a customer in Japan. The head of sales responsible for this contract enters a currency hedge of 500 million yen to mitigate the company’s exposure to loss on foreign currency exchange rates.
Unbeknownst to the head of sales, though, the company also purchases significant raw materials from a Japanese supplier and will purchase about one billion yen worth of supplies over the next year. Because the head of sales wasn’t aware of the company’s entire transaction base denominated in yen, the company took a neutral net exposure position (sales of one billion yen less purchases of one billion yen) and turned it into a 500 million-yen exposure by entering the hedge.
As this example demonstrates, appropriate decision-making regarding hedging requires comprehensive knowledge of the all of the company’s relevant activities. In other words, it requires an oversight committee.
More businesses are creating oversight committees to apply an enterprise approach to hedging. For a large company with global operations, members might include the CFO, controller, and vice president of operations, as well as representatives from the supply chain, procurement, human resources, and legal functions and the heads of major business units or other groups.
Including these players in the determination of the company’s hedging principles and strategies greatly improves the odds that all relevant information is considered and the proper hedging level is established.
The composition and conduct of each oversight committee will vary, depending on, for example, to whom the committee reports and whether it requires independent members. But every committee’s primary objectives or goals should include the following:
Satisfying these and other objectives requires solid planning and processes, but best practices are available to help do so.
Hedging can provide an organization with much value when it comes to assuming appropriate levels of risk in a volatile business environment – especially when an oversight committee is involved. No company will always win in hedging, but one with a committee will know its risk exposure and can proceed under a policy that facilitates decisions that align with the company’s risk appetite.
William Watts is a risk consulting principal at Crowe Horwath LLP and can be reached at 614-280-5227 or [email protected]Chad Zagar, senior manager for business risk services at Crowe Horwath, can be reached at 616 233 5564 or [email protected]