OUR THOUGHTS ON:

The Link Between Hedging and Risk Management

Energy & Resources

By Amy Kletch

The use of financial derivatives in the market has grown directly with the changing role of risk management. Risk management has changed based on the coming together of the traditional risk mitigation and overall portfolio optimization. There are two main sources of risk (price and operation) recognized by risk management teams to address both hedging needs and portfolio optimization. In other words, the who, what, when, why, and how of derivative use has become more important as the use of derivatives to ease the effects of volatility has increased.

The natural gas industry has embraced the use of financial derivatives (futures) for both speculative and hedging purposes. Evidence of this is the increased volume of natural gas futures contracts being traded each year due at least in part to the use of futures in risk mitigation. Derivatives, such as futures, are used by risk managers to hedge transactions that might otherwise result in large losses in the event of extreme price volatility. Hedging also makes it possible for companies to engage in activities that might not otherwise be pursued. Because the risk associated with a portfolio of hedged transactions is lower than the risk associated with a portfolio of un-hedged transactions, risk management considers hedging risk through the use of derivatives to be an important function.

Another primary risk management objective, in addition to mitigating price risk, is mitigating operation risk. Operation risk is mitigated through the clear establishment of allowable activities and a strong risk management culture at the business-wide and transaction levels. At the business-wide level, allowable business activity is regulated by risk management through the establishment of general guidelines and principles. At the transaction level, limits and controls are established on both a business and individual unit basis. The most familiar limits include net and absolute value volume limits, loss limits of various time horizons, and daily value-at-risk computations. Also, the trading industry standard is mark-to-market accounting, in addition to individualized documentation of allowable activity. Overall, using these measures creates a strong risk management culture and ensures risk mitigation and compliance. As the use of derivatives by traders and risk managers has grown, so has the importance of operation risk management measures.

Just as the roles or price risk abatement and portfolio optimization have merged, so to have the price and operation risk mitigation functions. This is important when determining an overall business strategy, or a particular hedging plan. Risk managers must keep both risk mitigation and portfolio optimization in mind when choosing a hedging strategy, especially when it comes to price volatility.

With risk management teams and their functions increasing in importance, the intersection of risk management and portfolio optimization is a guarantee. Their intersection is most apparent during periods of market volatility. In other words, the need for flexible strategies that attend to price and operation risk, as well as portfolio optimization, is especially important during periods of market volatility. A successful risk management strategy will address these sources of risk and the overall profitability of the portfolio.

Derivatives (futures) are a valuable part of any business risk management hedging strategy. There are also costs to using futures in the context of price volatility. Risk management is concerned with the how and with what tools are used to construct a hedge because of the large losses that might be associated with the use of futures for hedging. Most futures contracts are settled daily by the payment of variation margin from the party who has lost money that day to the party who has made money compared to a forward contract, which settles only when the contract matures. Consequently, there are other nontrivial costs to consider when hedging with futures contracts in an environment of market volatility.

Future hedges are used to reduce profit uncertainty and take advantage of price risk by acting as a substitute for a transaction that must take place in the cash market at a later time. This strategy assumes price movements in the cash market resulting in a loss will be offset by a gain in the futures market. When prices in the cash market do not mirror prices in the financial market, the hedge becomes costly and less effective.

Using futures without a clearly defined risk management strategy can threaten your long-term goals. When considering extreme price volatility and attempting to reduce risk and keep transaction costs low, futures may not be the most appropriate choice. An effective overall trading and risk management program must take into consideration measures that address both operation and price risk. Before using derivatives for hedging risk, consider all relevant costs, including the opportunity cost of holding futures contracts used to hedge existing business obligations, whether or not the underlying investment is “in the money.”

If you have questions on how you can most effectively manage your risks, contact Amy Kletch at akletch@schneiderdowns.com.

 

 

 

 

Schneider Downs provides accountingtax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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