Article Effective hedging strategies can mitigate growing risks

Effective hedging strategies can mitigate growing risks

Companies today use hedging strategies to manage a broad range of exposures spanning commodity market dislocations, currency volatility, interest rate fluctuations and more. But their efforts to mitigate these risks are not always successful.

Many companies are not prepared for the growing challenges of today's business environment, putting them at a significant and growing disadvantage.

Challenges of hedging

Navigating today's commodity and financial markets has grown increasingly difficult amid geopolitical uncertainty and inconsistent regulations across continents. Many large enterprises have considerable exposure to currency volatility and commodity pricing risks throughout their supply chains.

Businesses must grapple with the complexities of financial derivatives and interest rates for variable- and fixed-rate financial instruments. The volatility inherent in commodities trading has been an ongoing headache for industry participants, while foreign exchange (FX) transactions can be risky, especially if there are major discrepancies between counterparties. Managing risk through properly structured hedges while ensuring compliance with the appropriate regulatory measure remains complicated.

"All risks can compound over time," says Vincent Menna, Principal Product Manager at Openlink. "Corporations with complex structures have foreign exchange, interest rate and commodity risk. These risks do not occur in isolation. Companies need to manage these risks collectively, so they want a holistic view of their position to give them more transparency and visibility."

The impact of poorly managed hedges

A growing body of research illustrates the extent and cost of inefficient hedging and risk management. For example, Deloitte's 2016 Global Foreign Exchange Survey of 133 companies found that 60 percent felt their currency hedges were hurt by a lack of visibility driven by complexity and inadequate investment in automation. The impacted companies span consumer and industrial products; energy and resources; banks; life sciences and healthcare; and technology, media and telecommunications.

Another study from Ernst & Young, Expecting More from Risk Management, finds that companies are facing a grave threat and lost opportunities from their inability to recognize and manage increasing uncertainties in today's volatile environment.

A path to improved return on investment

It is difficult for companies to optimize hedging activities when key information is scattered across multiple systems and channeled through operational silos. Many use old-fashioned spreadsheets or outdated technology. Hedging strategies can help to stabilize cash flows and revenue — if companies have the right tools.

As part of a single-platform, enterprise-wide trading and risk management system, real-time hedging solutions that are informed by real-time position and risk analysis offer the potential to significantly boost corporate profitability. For example, an Openlink/Hobson & Co. study of gas and power companies and cross-commodity players found that even one inadequate hedge can cost an organization hundreds of thousands of dollars in value lost.

One gas and power company that had five losses per year due to inadequate hedges or poorly managed risks could potentially save $10.2 million a year by implementing a comprehensive energy trading and risk management (ETRM) system that helps measure and maximize hedge effectiveness in real-time. The improvements facilitated by such an ETRM system would also include decreased IT spending, higher operational efficiency, improved compliance and risk management, and business growth.

The study found a five-year investment of $12.1 million in a comprehensive ETRM generated a positive return in 18.1 months, with a five-year net present value (NPV) and Return on Investment (ROI) of $21.8 million and 260 percent, respectively.

The bottom line

Hedging strategies, if appropriately set in place, help improve decision-making and deliver better outcomes. They help break down operational silos to connect data and information systems from across an organization into a consolidated view. Most important, they help companies identify emerging opportunities and fuel better performance. In the complex, shifting environment companies are facing today, modernizing and streamlining hedging strategies and processes should take center stage.

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