Benchmarking Risk Management Performance
A metals industry executive once asked me, after a presentation on the wonders of risk avoidance by hedging, – “Do you mean to say you go to all this effort just to break even?” I was taken aback, but the reality is that breaking-even is better than going bankrupt – and enhancing your bottom line is better still. Either way you don’t know how to justify “all this effort” unless you benchmark your performance. The CEO and CFO are entitled to see what they get in turn for funding the company’s risk management efforts. Here is a good place to start.
- Top-Down Comparison. Income volatility is inherent in unmanaged commodity risk taking by a manufacturer. It may be positive – dumb luck – but it is always unexpected and uncontrolled. The first benchmark should be to measure the financial performance of the business unhedged, secondly fully hedged, and thirdly hedged with the degree of discretion you apply – your actual hedge transactions. These two comparisons with naked risk will show:
- How closely you could neutralize it with perfect hedging, and
- How well you actually did – a guide to overall risk management performance
- Contributory Factors. The overall top-down tool is a bit of a blunt instrument. Customer and supplier pricing practices, delivery slippage, correlation between commercial price indices and hedge instruments, are all factors in risk management performance, but outside the control of the hedge executor. Hedge execution and forward spread management are other factors which are within his control. Under the umbrella benchmark you must have sectional benchmarks which can be directed at the supply chain manager, the sales manager, even the production manager, as well as the hedge manager.
- Particular Impacts. This is a typical but not exclusive list of impacts to be benchmarked – you need a risk management expert to help you identify the factors your business encounters:
- Matching of invoiced metal prices against linked hedge prices – to highlight look-back options or other manipulative customer practices
- Slippage between order quantities and delivered quantities – cancellations and under/over shipments which can thwart hedge outcomes – attributable to counterpart action or production failure
- Gain/loss from hedging excess inventory surges
- Effective correlation between your price list and the hedge instrument
- Difference between hedges given by the hedge manager to commercial staff and hedge transactions executed with brokers
- Difference between hedge spread gains/losses captured by the hedge manager and the highs and lows offered by the market
- Benchmarking Tools. First of all, you need targets – what are you benchmarking to in each of the areas you have isolated – break-even, $5/MT worst case loss, maybe 0.5% gain. These should be part of your RM policy discussion, and should be formulated with expert help. Then you need effective measurement tools:
- Linkage between commercial transactions and hedges to be captured in your CPRM system
- Ability for your system to mark-to-market – it is the only way to measure the financial gain/loss on a 16.2-ton shipment of a 20-ton order hedged with a 25 ton LME hedge transaction
- Custom-built reports – probably designed to incorporate downloads from your ERP system into the CPRM system, and from the CPRM system into spreadsheet pivot tables – again usually designed with the help of experts like CRMA/CRCI
- Performance Enhancements. Lastly there is no point in setting targets and measuring performance unless your managers realize that these will carry consequences for them. Manager evaluations, including all the managers in the risk chain, not just the hedge guy, and incentives for improvement are vital in driving the results of your benchmarking to the bottom line. It is helpful to get guidance from an expert in setting up this process too.