Does technology hold the key to commodity hedging?

Market Insight

How the right technology solution can support an effective commodity hedging and risk management strategy

Over the past decade, many firms were forced to reassess their approach to risk management in face of increased price volatility across international commodity markets, in particular, due to the dramatic drop in oil prices between 2014 and 2016.

Implementing more effective hedging strategies has frequently met the objective of reduced price risk and earnings volatility, and the impact of these strategies has often become a competitive advantage to the companies concerned. When designing a hedging strategy, a series of steps need to be taken, starting with the key strategic objectives of management and shareholders. Once the right strategy has been arrived at, robust and bespoke technology solutions are required to be able to deliver it.

An implementation stage seeks to collect the relevant risk data and metrics across the business so that management and decision making can be performed. Then the ongoing process is a setup that combines appropriate quantitative analysis daily alongside market intelligence. There are clear benefits in decision making being done in one place as opposed to scattered across organisations, and the right technology solution can enable this.

Risk management process – building a framework and implementing a strategy

Technology as an enabler

Although the benefits of a holistic hedging strategy and framework are widely recognised, there are also innumerable examples of organisations making costly decisions due to the lack of coordination between different strands of their business e.g. a department undertaking expensive financial hedges unaware of natural hedges already in place or exposures in their pension schemes, leading to an opposite increase of the net exposure instead of the desired reduction.

As organisations grow in complexity, with multiple departments undergoing their own risk management, such risks only increase. Advances in technology have made it easier to combine exposures and the related hedges within a single monitoring department, often across traditionally separated sector types, such as currencies and commodities. Using spreadsheets to manage such processes would normally be sufficient on a small scale but as a business grows in complexity, spreadsheets become impractical and a risk in their own right. Technology in this instance can be used effectively to aggregate demand forecasts and actuals and determine the net exposure to each different factor.

The team in charge of risk management normally receives inputs from different departments and enters these into a master system, which then allows the team to hedge defined, relevant net risk exposures, and suitably procure the appropriate hedging transactions in the market.

Such a shift in technology has driven changes in attitudes in the organisational design as the hedging role has often fallen to treasury. This has resulted in FX and commodity risk management becoming increasingly relevant in a treasurer’s agenda, a markedly different view compared to less than a decade ago. A sophisticated platform that can run portfolio risk analysis, as well as deal with daily operations, can add significant value to the treasury function.

Implementation challenges

There is still a gap between setting a hedging framework supporting the consolidation of risk management in one department and the reality of organisations often being riddled with overlapping legacy systems across different departments. This can result in inefficiencies, duplication of work and a heightened level of undue risk which breed implementation stage challenges.

Centralisation of tasks both simplifies the business infrastructure and reduces cost but requires careful planning. It can often be an intense project management process that drains significant time and resource, and a barrier to a successful implementation of the optimal hedging framework. Centrus has supported such system development, and provision of market data successfully delivering efficiencies to organisations, streamlining projects by integrating and simplifying system architecture and driving valuable efficiency savings.

However, a system solution is only an enabler. In the first instance, a properly supported and aligned risk management framework is the essential starting point from which to develop an effective hedging strategy. Both elements require the buy-in of senior management, without which even the best system will struggle to make a difference. As always, a hedging strategy is only as good as the people and management driving it. An effective technology and system partner can make the difference in ensuring that the selected strategy can be successfully and effectively delivered in a business-enhancing fashion.

Technology has also driven other corporate changes:

  •  Transparency: Boards and executive teams demand better visibility of the company’s net exposures, often in real-time, as a response to increased volatility in markets and demand for transparency.
  •  Regulatory: Businesses, mindful of the changing regulatory environment such as the introduction of MiFID II, EMIR and Dodd-Frank which may cause an impact on non-financial businesses, are often using technology to produce more comprehensive and detailed disclosures.
  • Hedging Strategy: Technology is featured in business review processes to fine-tune or re-establish existing hedging frameworks analysing the information on the prices achieved and the performance against targets.

Case Study: Risk Reporting & Derivative Valuation Services for a Major Airline

Streamlining internal treasury & risk management systems:
  • Previously had 4-5 TMS and Trading system licenses (FX and Fuel)
  • Risky and intensive spreadsheet calculation and reporting
  • Complex valuations approximated by substandard systems
  • Desire to streamline and upgrade risk management

Centrus designed the following solution for a global airline:
  • Set-up automated feeds of business exposures and hedging portfolio to Centrus’ platform, removing existing systems
  • Customised reporting deliverables
  • Daily Dashboards – Daily MTM Valuations / Collateral calls – Potential Expected and Future Exposure (EPE/PFE) – Daily Hedging Position for FX and Fuel: Open exposures / hedged positions across time
  • Performance against policy
  • Monthly Reports: 1. Risk sensitivity, 2. Monthly MTM valuation for accounting, 3. Monthly settlement report, 4. CVA/DVA, asset liability split
  • Value at Risk: Application of different hedging strategies to VaR calculations – Weekly cash sensitivity reporting based on VaR outputs (CFaR)
  • Enhanced Reporting Daily dashboards received early in the morning with up-to-date portfolio position and valuation information.
  • Reduced Cost savings from system replacement and removal of internal spreadsheet processes.
  • Pertinent Advice: Centrus and the airline are working closely together to ensure hedging strategy is fit to wider internal goals and appropriately communicated to internal stakeholders, keeping up to date with the latest market practices.

Centrus Risk

Centrus Risk provides independent valuations and risk analyses of complex OTC derivatives and structured products. Centrus has both quantitative and technological expertise in delivering valuations, analyses and specialised reporting. Centrus Risk system framework consists of sophisticated rules engine which allows us the flexibility to adapt to new requirements and market demands. We believe it’s imperative that this service is coupled with unparalleled customer support consisting of professionals from diverse backgrounds, such as accountants, treasurers and derivative specialists.

Key Benefits
  •  Automated Financial Disclosures Reports – Information for your business and accounts in the format you require
  • Automated Hedge Accounting
  • Automated MTM Reports
  • Valuations & Cashflows on Complex Positions
  • Potential Future Exposure (PFE) Calculations
  • Hedging Advice and Analyses
  • Value at Risk (VaR) calculations
  • EMIR Reporting

About Centrus

Centrus offers leading derivative, debt and treasury technology and advisory services for Corporates, Banks, Custodians & Fund administrators, Insurance companies, Pension, Debt & REIT funds. Our highly experienced team has a wide variety of backgrounds enabling us to provide our clients with expertise across: Treasury and Derivatives,  Systems, Reporting & Valuation Services, Capital Raising and Corporate Finance.

For more information, please contact Gilles Bonlong, Director – Centrus