Developing an effective corporate hedging policy

Second pillar involves defining the who and what of the policy. Who is responsible for the hedging policy? Who is going to be responsible for ensuring that the company adheres to policy? Who is responsible for developing, implementing and managing the hedging policy and accompanying strategies and procedures? A hedge committee, chief accountant, risk manager, etc.?

Who is responsible for selecting appropriate counterparties and/or derivatives brokers/clearing members and what criteria will be used to evaluate them? And who is responsible for continuous monitoring and risk reporting?

What type of transactions will be permitted? Forwards, futures, swaps, options? What indices will be permitted i.e. Dubai/Oman crude oil, ICE Coffee Futures, Singapore jet fuel, etc.? What resources (manpower, risk management systems, commodity market data, etc.) will said individuals and/or teams need to properly carry out their responsibilities? For example, the effectiveness of risk management metrics, such as stress testing, is essential for assessing the degree of vulnerability of the business under extreme conditions like a pandemic.

If the market trends unfavourably against the hedged exposure and the derivative fails to fulfil its hedging requirements (that is, does not offset the anticipated losses of the hedged exposure) or the chosen structure proves faulty as highlighted in my previous article on KQ, the primary purpose of the hedge is undermined. This situation could result in increased risk and a higher utilisation of the company’s credit lines.

The third pillar deals with the practical aspects of executing derivative trades or the why, when and how. When and how will existing positions be reviewed to ensure that they are still appropriate given the company's risk tolerance, hedging policy and current market conditions? When and how will the various risks (market, credit, operational, regulatory) be measured and by whom? When and why will transactions be executed?

How often should the policy be reviewed and by whom? This is to guarantee that the company consistently aligns with its core hedging objectives and does not deviate from them.

Clearly there are a lot of issues to be explored when developing a hedging policy but by adhering to the three core pillars outlined above, companies can ensure that their use of derivatives is prudent, purposeful and perfectly tailored to their specific needs.

A well-designed hedging plan will cut both risks and costs. Additionally, it allows management to focus on aspects of the firm in which it has a competitive edge by minimising risks that are not central to the core business.

Mwanyasi is MD, Canaan Capital