Risk of Hedging

10 Key excerpts on "Risk of Hedging"

• 

  eBook - ePub

  Energy Trading and Risk Management

  A Practical Approach to Hedging, Trading and Portfolio Diversification

  • Iris Marie Mack(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Hedging strategies generally involve the use of derivatives, such as those introduced in Chapters 2, 3, and 4. Derivatives, when well understood and properly utilized, are beneficial to help energy market participants manage risks through trading and structured hedging strategies. In this chapter we

  • Discuss the role of hedging in energy trading and risk management
  • Lay the groundwork for the next chapter, where we examine how energy derivatives are utilized in various hedging strategies

  HEDGE

  A hedge is an investment that reduces the risk of adverse price movements in an asset.

  Hedging against risk involves the purchasing of financial instruments to offset the risk of adverse price movements.

  What is a hedge? What is hedging?

  A hedge is an investment that reduces the risk of adverse price movements in an asset. Technically, a basic hedge consists of investing in two assets with a negative correlation (statistical measurement of how two assets move in relation to each other).

  Hedging against risk involves the purchasing of financial instruments to offset the risk of adverse price movements.

  If a market participant employs a hedging strategy it may incur an inevitable tradeoff between risk and return.

  One way to grasp the concept of hedging is to think of it as insurance. When energy and financial market participants implement hedging strategies they are insuring themselves against a negative event. Hedging does not prevent a negative event from occurring. If the negative event does occur and the market participant is properly hedged, then any negative impact should be minimized. In financial and energy markets, hedging is more complicated than the payment of insurance premiums.

  Regulatory rules may play an important role in hedging strategies (Deng and Oren 2006). In addition, hedging of risk by a corporation is often motivated by the goal of maximizing the firm’s value via the reduction of the

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  The Portable MBA

  • Kenneth M. Eades, Timothy M. Laseter, Ian Skurnik, Peter L. Rodriguez, Lynn A. Isabella, Paul J. Simko(Authors)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  The science of financial hedging has become increasingly sophisticated and more quantitative over the years. Understanding how to use financial instruments for hedging therefore requires some study of statistics as well as a close look at the instruments themselves. Even though the objective of hedging might appear straightforward, it was inadequate risk management during the subprime mortgage crisis that ultimately spelled ruin for financial institutions such as Bear Stearns and Lehman Brothers. In these cases the principles of hedging were not flawed, but rather it was the implementation and the underlying assumptions of the risk models that were flawed. Despite these extreme examples, the financial industry and the use of derivatives and financial hedging will continue to be a mainstay of financial strategies in the future. Like the broader topic of enterprise risk management, hedging also has a certain vocabulary that facilitates thinking about risk and whether it should be hedged, and if so, how it should be hedged. With this in mind, the remainder of the chapter is organized as follows:

  • Risk and statistical analysis.
  • Futures and options contracts.
  • The hedging decision.

  Risk and Statistical Analysis

  We start the study of financial hedging with a quick review of how a statistician would describe risk. When asked, most people would define risk as the possibility that something bad will happen in the future. For the study of risk, however, we need to find a more useful and usable definition. Because statistics are a means of quantifying uncertainty as a measure of risk, business managers must think about risk within this framework. Statistics incorporate the study of probabilities within which we can define risk as the uncertainty, both upside and downside, around an expected value. For example, if a business analyst was making a forecast of company sales for next year, the analyst’s best guess would be the expected value around some distribution, as illustrated in Exhibit 15.2 .

  The expected value is the midpoint of the potential outcomes; that is, it represents the value for which it is equally likely that the realized value will be either higher or lower than the forecast. If the firm performs better than expected, the realized value will fall to the right of the expected value in the “good news” part of the distribution. If the firm performs worse than expected, the realized value will fall to the left of the expected value in the “bad news” half of the distribution.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Essentials of Financial Risk Management

  • Karen A. Horcher(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  Risks are events and described as high or low probability. If an event occurs, it has the potential for losses that range in size from small to large. Often, one measure is high and the other is low—for example, a high probability of a small loss. This type of loss might be represented by routine exchange rate fluctuations.

  The most dangerous risks are those with a low probability of occurring but the potential for a large loss. Sometimes known as icebergs, these risks appear suddenly and can result in large losses. The failure of a counterparty and the resultant loss could be an example of such a risk.

  Once an acceptable level of exposure has been established, management can determine how to reduce the potential for loss to an acceptable level. Competitive Landscape

  An important consideration in making hedging decisions is the expected activity of competitors. If an organization hedges and its major competitors do not, the organization may be at a disadvantage if market rates or prices move favorably. The reverse is also true. If the organization hedges and exchange rates move adversely, the organization may have an advantage over its competitors.

  Changes to an organization’s pricing structure, as a result of changing costs, may cause customers to buy or consume more or less. Financial risk can sometimes be passed on to customers or end users in the form of price adjustments, reducing the impact to the organization. This is most often possible when demand is inflexible or slow to react to price changes.

  The activities of competitors and the market affect the competitive landscape in the following ways:

  • Propensity of customers to accept risk through rising prices
  • Willingness of vendors to offer fixed-price contracts or dual-currency pricing
  • How products are priced
  • Where product inputs, including commodity components, are sourced
  • Alternative inputs to products and sources of inputs
  • Commodity components

  Board and Management: Role, Requirements, and Challenges

  Management typically develops risk management policy, while the board of directors has responsibility for its approval. As representatives of shareholders, the board’s responsibilities include oversight of management. Given the potential for substantial losses, boards are especially concerned about financial risk management and its implications in these key areas:

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  The Routledge Companion to Strategic Risk Management

  • Torben Andersen(Author)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  Treanor, S. D., Simkins, B. J., Rogers, D. A. & Carter, D. A. (2014). Does operational and financial hedging reduce exposure? Evidence from the US airline industry. Financial Review 49(1), 149–172. Passage contains an image

  7 Reflections on integrated risk management

  Kent D. Miller1

  DOI: 10.4324/9781315780931-10

  Risk researchers in the various fields of business have tended to examine particular sources of risk in isolation (Miller, 1992 ). International management researchers highlight risks owing to political and economic instability, government policy changes, or social unrest. Finance researchers focus on managing the categories of risk for which hedging and insurance instruments apply, such as movements in commodity prices, interest rates, and exchange rates. Operations and management researchers consider hazards arising within particular functional activities, across supply chains, and in dynamic markets.

  A strategic management perspective encompasses all of these concerns, and brings a particular emphasis to the role of competitive strategies in creating and ameliorating organizational risk. Moves by rivals, new entrants, and technological breakthroughs present risks and rewards as they transform industries. Strategists have available a diverse repertoire of possible responses to manage risk, including avoidance or control of risky situations, collaboration with other organizations to reduce uncertainty, imitation or follow-the-leader coordination, and developing operational and strategic flexibility.

  Strategic managers are uniquely positioned to consider the organization in relation to its environment, and to do so in a way that encompasses intra-organizational, industry, and general environmental risks. Strategic managers are charged with assessing and managing diverse risks, and they need ways to think about, discuss, and carry out these complex responsibilities. My 1998 article, “Economic Exposure and Integrated Risk Management,” contributed to the conceptual framing and methodology of assessing and managing diverse risk exposures in an integrated manner. Viewing the organization in relation to its environment with a view toward enhancing firm value, as that article does, reflects defining concerns in the strategy field.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Commodity Derivatives

  Markets and Applications

  • Neil C. Schofield(Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Liquidity risk – liquidity risk can be thought of as the potential inability of a company to meet its short‐term cash requirements. This may arise from the inability to borrow money from its bankers, or the inability to be able to liquidate assets to cover any shortfall.
• Commodity risk – simply, this is the exposure that a company will face because of a change in commodity prices. This may be either explicit or as a side product of a company's business. For example, a gold producer will be exposed to a fall in the price of the commodity, which is a direct function of his production. A haulage company's exposure to diesel prices is arguably a secondary exposure to their main line of business. A company that is fully integrated along a particular supply chain will arguably face offsetting price risks.

Credit risk

The other main risk from the ‘big five’ noted previously that can be hedged is credit risk; although the use of credit derivatives is outside the scope of this book.

To illustrate the principles let us consider the issues faced by a consumer of base metals within the automotive sector. It would be possible for them to enter direct physical hedging contracts with the producers of the metal, but this is not without difficulty. There would be three main risks that the producers would face. Firstly, there is the issue of product specification. Hedging directly with say a mine is not necessarily a good idea, as they will not be producing the metal in its primary form. It is more likely to be in an intermediate form that needs further work to make it usable by the consumer. Although a physical hedge may be possible with a smelting company, there is still no guarantee that they will be able to produce the metal in the exact specification required. The second issue relates to the counterparty credit risk. If either the mine or the smelter suffers any operational problems, they may not be able to meet their future physical obligations. Finally, there is the issue of price expectations. Consumers of the metal will be looking to hedge at times when the commodity price is at the bottom of the price cycle, while producers will be looking to hedge towards the peak of prices.