Hedging when it matters

The determinants of when producers, consumers and other merchant participants use futures and options

Having a well-oiled risk management system is widely accepted as critical to modern business and enterprise. But a recent study found that the rationle for firms to manage exposure to markets, such energy prices, prices of industrial metals and the prices of food commodities and how it is interpreted from a hedge accounting perspective is not so clear cut. While managing risk, sounds like a good idea, when it comes to these examples, market conditions should not be ignored.

The rationale to use hedge accounting tactics for producers of physical commodities such as cotton is unclear. Image courtesy of DJI-Agras / Pixabay.

In the last few years there have been several major changes by the Financial Accounting Standards Board (FASB) to enhance transparency and address key practices in the complex area of hedge accounting. The objective was to better align hedge accounting with an organisation’s risk management activities in the financial statements. In addition, the FASB simplified the application of hedge accounting guidance in areas where issues existed.

It’s been long argued that hedging may not be necessary when investing in firms with a physical commodity (e.g. airlines, haulage firms, oil companies). This is because through the use of futures and options, they are able to mitigate exposure to higher prices and their volatility.

However, despite the changes set by the FASB, the rationale for hedging exposures for organisations who produce, refine or distribute or use physical commodities such as coffee, copper and cotton is unclear.

Are market conditions a factor?

Dr Lawrence Haar and Prof. Andros Gregoriou, both finance lecturers and researchers at University of Brighton’s School of Business and Law, have recently published research suggesting that a considerable body of published research in which hedging activities were not prevalent despite the financial logic, should be revisited to examine the role of market conditions.

Dr Haar explains: “Hedging is a well-used strategy by organisations, you can think of as a bit like insurance – where organisations offset potential losses in investments by taking an opposite position in a related asset. For example, an oil company might hedge against the price of oil falling but hedging when prices are low does not make a great deal of sense.  But when prices are high or very volatile, hedging through futures and options can make lots of sense. Hence, the need to look at relevant market conditions rather than advocating ‘risk management’ in the abstract.

“Though the efforts by the FASB has seen a marked effort to measure the benefits of managing risk, consideration has not been given to how efforts to manage costs or protect revenues or avoid losses, may have been related to the variability of prevailing risk factors.”

If markets for commodities such as copper are fairly static, why would those organisations need to apply hedge accounting tactics to mitigate risk? Copper mine image courtesy of jdblack / Pixabay

Their research surmises that although improved rules for Hedge Accounting may have made risk management easier to conduct, if managing risk under prevailing market conditions do not make sense, then such reforms in of themselves will not encourage usage. Or, to put simply, regardless of the financial logic for hedging risk, if markets are perceived as stable, why bother?

This article is based on the published research of Dr Lawrence Haar and Professor Andros Gregoriou of the University of Brighton School Business and Law: “Risk management and market conditions”, International Review of Financial Analysis, Volume 78, November 2021, 101959 (https://doi.org/10.1016/j.irfa.2021.101959)