12/9/2014

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Therightwaytohedge
Decidinghowandwhattohedgerequiresacompanywidelookatthetotalcostsandbenefits.
July2010 |by BryanFisherandAnkushKumar

Hedgingishot.Shiftsinsupplyanddemanddynamicsandglobalfinancialturmoil
havecreatedunprecedentedvolatilityincommoditypricesinrecentyears.Meanwhile,
executivesatcompaniesthatbuy,sell,orproducecommoditieshavefacedequally
dramaticswingsinprofitability.Manyhavesteppeduptheiruseofhedgingtoattemptto
managethisvolatilityand,insomeinstances,toavoidsituationsthatcouldputa
companyssurvivalinjeopardy.

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Whendonewell,thefinancial,strategic,andoperationalbenefitsofhedgingcango
beyondmerelyavoidingfinancialdistressbyopeningupoptionstopreserveandcreate
valueaswell.Butdonepoorly,hedgingincommoditiesoftenoverwhelmsthelogic
behinditandcanactuallydestroymorevaluethanwasoriginallyatrisk.Perhaps
individualbusinessunitshedgeoppositesidesofthesamerisk,ormanagersexpendtoo
muchefforthedgingrisksthatareimmaterialtoacompanyshealth.Managerscanalso
underestimatethefullcostsofhedgingoroverlooknaturalhedgesindeferencetocostly
financialones.Noquestion,hedgingcanentailcomplexcalculationsanddifficulttrade
offs.Butinourexperience,keepinginmindafewsimplepointerscanhelpnipproblems
earlyandmakehedgingstrategiesmoreeffective.

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Therightwaytohedge

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Toomanyhedgingprogramstargetthenominalrisksof
siloedbusinessesratherthanacompanysneteconomic
exposureaggregatedriskacrossthebroadenterprise
1

thatalsoincludestheindirectrisks. Thissiloed
approachisaproblem,especiallyinlargemultibusiness
organizations:managersofbusinessunitsordivisions
focusontheirownriskswithoutconsideringrisksandhedgingactivitieselsewherein
thecompany.

Elsewhere,thepurchasingmanagerofalargechemicalcompanyusedthefinancial
marketstohedgeitsdirectnaturalgascostswhichamountedtomorethan$1billion,
orhalfofitsinputcostsfortheyear.However,thecompanyssalescontractswere
structuredsothatnaturalgaspricesweretreatedasapassthrough(forexample,withan
indexbasedpricingmechanism).Thecompanysnaturalpositionhadlittleexposureto
gaspricemovements,sincepricefluctuationswereadjusted,orhedged,initssales
contracts.Byaddingafinancialhedgetoitsinputcosts,thecompanywassignificantly
increasingitsexposuretonaturalgaspricesessentiallylockinginaninputpriceforgas
withafloatingsalesprice.Iftheoversighthadgoneunnoticed,a20percentdecreasein
gaspriceswouldhavewipedoutallofthecompanysprojectedearnings.
Keepinmindthatneteconomicexposureincludesindirectrisks,whichinsomecases
2

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Thematerialonthispage
drawsontheresearch
andexperienceof
McKinseyconsultants
andothersources.To
learnmoreaboutour
expertise,pleasevisitthe
RiskPractice.

Hedgeneteconomicexposure

Atalargeinternationalindustrialcompany,forexample,onebusinessunitdecidedto
hedgeitsforeignexchangeexposurefromthesaleof$700millioningoodstoBrazil,
inadvertentlyincreasingthecompanysnetexposuretofluctuationsinforeigncurrency.
Theunitsmanagershadntknownthatasecondbusinessunitwasatthesametime
sourcingabout$500millionofgoodsfromBrazil,soinsteadofthecompanysnatural
$200millionexposure,itendedupwithanetexposureof$500millionasignificant
riskforthiscompany.

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accountforthebulkofacompanystotalriskexposure. Companiescanbeexposedto
indirectrisksthroughbothbusinesspractices(suchascontractingtermswithcustomers)
andmarketfactors(forinstance,changesinthecompetitiveenvironment).Whena
snowmobilemanufacturerinCanadahedgedtheforeignexchangeexposureofitssupply
costs,denominatedinCanadiandollars,forexample,thehedgesuccessfullyprotectedit
fromcostincreaseswhentheCanadiandollarroseagainsttheUSdollar.However,the
costsforthecompanysUScompetitorswereindepreciatingUSdollars.Thesnowmobile
makersneteconomicexposuretoarisingCanadiandollarthereforecamenotjustfrom
highermanufacturingcostsbutalsofromlowersalesasCanadiancustomersrushedto
buycheapersnowmobilesfromcompetitorsintheUnitedStates.

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Insomecases,acompanysneteconomicexposurecanbelowerthanitsapparent
nominalexposure.Anoilrefinery,forexample,facesalargenominalexposuretocrude
oilcosts,whichmakeupabout85percentofthecostofitsoutput,suchasgasolineand
diesel.Yetthecompanystrueeconomicexposureismuchlower,sincetherefineries

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Therightwaytohedge|McKinsey&Company
acrosstheindustrylargelyfacethesamecrudepriceexposure(withsomeminor
differencesforconfiguration)andtheytypicallypasschangesincrudeoilpricesthrough
tocustomers.Soinpractice,eachrefinerystrueeconomicexposureisasmallfractionof
itsnominalexposurebecauseoftheindustrystructureandcompetitiveenvironment.
Toidentifyacompanystrueeconomicexposure,startbydeterminingthenaturaloffsets
acrossbusinessestoensurethathedgingactivitiesdontactuallyincreaseit.Typically,
thecriticaltaskofidentifyingandaggregatingexposuretoriskonacompanywidebasis
involvescompilingaglobalriskbook(similartothoseusedbyfinancialandother
tradinginstitutions)toseethebigpicturethedifferentelementsofriskonaconsistent
basis.

Calculatetotalcostsandbenefits
Manyriskmanagersunderestimatethetruecostofhedging,typicallyfocusingonlyon
thedirecttransactionalcosts,suchasbidaskspreadsandbrokerfees.These
componentsareoftenonlyasmallportionoftotalhedgecosts(Exhibit1),leavingout
indirectones,whichcanbethelargestportionofthetotal.Asaresult,thecostofmany
hedgingprogramsfarexceedstheirbenefit.

Exhibit1
Directcostsaccountforonlyafractionofthetotalcostofhedging.

Enlarge

Twokindsofindirectcostsareworthdiscussing:theopportunitycostofholdingmargin
capitalandlostupside.First,whenacompanyentersintosomefinancialhedging
arrangements,itoftenmustholdadditionalcapitalonitsbalancesheetagainstpotential
futureobligations.Thisrequirementtiesupsignificantcapitalthatmighthavebeen
betterappliedtootherprojects,creatinganopportunitycostthatmanagersoften
overlook.Anaturalgasproducerthathedgesitsentireannualproductionoutput,valued
at$3billioninsales,forexample,wouldberequiredtoholdorpostcapitalofaround$1
billion,sincegaspricescanfluctuateupto30to35percentinagivenyear.Ata6percent
interestrate,thecostofholdingorpostingmargincapitaltranslatesto$60millionper
year.
Anotherindirectcostislostupside.Whentheprobabilitythatpriceswillmovefavorably
(rise,forexample)ishigherthantheprobabilitythattheyllmoveunfavorably(fall,for
example),hedgingtolockincurrentpricescancostmoreinforgoneupsidethanthe
valueofthedownsideprotection.Thiscostdependsonanorganizationsviewof
commoditypricefloorsandceilings.Alargeindependentnaturalgasproducer,for
example,wasevaluatingahedgeforitsproductionduringthecomingtwoyears.The
priceofnaturalgasinthefuturesmarketswas$5.50permillionBritishthermalunits
(BTUs).Thecompanysfundamentalperspectivewasthatgaspricesinthenexttwoyears
wouldstaywithinarangeof$5.00to$8.00permillionBTUs.Byhedgingproductionat
$5.50permillionBTUs,thecompanyprotecteditselffromonlya$0.50declineinprices
andgaveupapotentialupsideof$2.50ifpricesroseto$8.00.

Hedgeonlywhatmatters
Companiesshouldhedgeonlyexposuresthatposeamaterialrisktotheirfinancial
healthorthreatentheirstrategicplans.Yettoooftenwefindthatcompanies(under
pressurefromthecapitalmarkets)orindividualbusinessunits(underpressurefrom
managementtoprovideearningscertainty)adopthedgingprogramsthatcreatelittleor
novalueforshareholders.Anintegratedaluminumcompany,forexample,hedgedits
exposuretocrudeoilandnaturalgasforyears,eventhoughtheyhadaverylimited
impactonitsoverallmargins.Yetitdidnothedgeitsexposuretoaluminum,whichdrove
morethan75percentofmarginvolatility.Largeconglomeratesareparticularly
susceptibletothisproblemwhenindividualbusinessunitshedgetoprotecttheir
performanceagainstrisksthatareimmaterialataportfoliolevel.Hedgingthesesmaller
exposuresaffectsacompanysriskprofileonlymarginallyandisntworththe
managementtimeandfocustheyrequire.
Todeterminewhetherexposuretoagivenriskismaterial,itisimportanttounderstand
whetheracompanyscashflowsareadequateforitscashneeds.Mostmanagersbase
theirassessmentsofcashflowsonscenarioswithoutconsideringhowlikelythose

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Therightwaytohedge|McKinsey&Company
scenariosare.Thisapproachwouldhelpmanagersevaluateacompanysfinancial
resilienceifthosescenarioscametopass,butitdoesntdeterminehowmaterialcertain
risksaretothefinancialhealthofthecompanyorhowsusceptibleitistofinancial
distress.Thatassessmentwouldrequiremanagerstodevelopaprofileofprobablecash
flowsaprofilethatreflectsacompanywidecalculationofriskexposuresandsourcesof
cash.Managersshouldthencomparethecompanyscashneeds(startingwiththeleast
discretionaryandmovingtothemostdiscretionary)withthecashflowprofiletoquantify
thelikelihoodofacashshortfall.Theyshouldalsobesuretoconductthisanalysisatthe
portfolioleveltoaccountforthediversificationofrisksacrossdifferentbusinesslines
(Exhibit2).

Exhibit2
Companiesshoulddevelopaprofileofprobablecashflowsaprofilethatreflectsacompany
widecalculationofriskexposuresandsourcesofcash.

Enlarge

Ahighprobabilityofacashshortfallgivennondiscretionarycashrequirements,suchas
debtobligationsormaintenancecapitalexpenditures,indicatesahighriskoffinancial
distress.Companiesinthispositionshouldtakeaggressivesteps,includinghedging,to
mitigaterisk.If,ontheotherhand,acompanyfindsthatitcanfinanceitsstrategicplans
withahighdegreeofcertaintyevenwithouthedging,itshouldavoid(orunwind)an
expensivehedgingprogram.

Lookbeyondfinancialhedges
Aneffectiveriskmanagementprogramoftenincludesacombinationoffinancialhedges
andnonfinancialleverstoalleviaterisk.Yetfewcompaniesfullyexplorealternativesto
financialhedging,whichincludecommercialoroperationaltacticsthatcanreducerisks
moreeffectivelyandinexpensively.Amongthem:contractingdecisionsthatpassrisk
throughtoacounterpartystrategicmoves,suchasverticalintegrationandoperational
changes,suchasrevisingproductspecifications,shuttingdownmanufacturingfacilities
wheninputcostspeak,orholdingadditionalcashreserves.Companiesshouldtestthe
effectivenessofdifferentriskmitigationstrategiesbyquantitativelycomparingthetotal
costofeachapproachwiththebenefits.

Thecomplexityofdaytodayhedgingincommoditiescaneasilyoverwhelmitslogicand
value.Toavoidsuchproblems,abroadstrategicperspectiveandacommonsense
analysisareoftengoodplacestostart.
Abouttheauthors
AnkushKumarandBryanFisherarepartnersinMcKinseysHoustonoffice.

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Therightwaytohedge|McKinsey&Company

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