What Should a Price Risk Management Program Measure?

We talk a lot about visibility and accountability, but what needs to be visible and what must we be accountable for? Price Risk Management is a relatively new field and a lot of business executives don’t really know what to look for. We understand what metrics we need to describe production, sales, inventory and working capital – but what about concepts like net exposure, price mismatch and mark-to market valuation? How can we make them leap from the page? Where do they fit into the pecking order of numbers whose bottom line is P&L or Shareholder Equity?

Standard Accounting Practice isn’t even that helpful. Hedge Settlements often have their own line, as does Unrealized Hedge Position Gain/Loss but what on earth do they mean without a connection to the underlying commercial transactions and assets they are hedging. Failure to connect these two strands can lead to commercial managers boasting about their sales performance and leaving the hedge manager to take the blame for the mirror image in the hedge account, or, when they do poorly, claiming that their poor results are all offset by positive hedge outcomes. Senior financial managers may understand that commercial price volatility is being offset by hedging, but, without clear metrics they don’t know how much is being offset, how effective is the hedge and how successful is the discretionary side of price risk management.

Hedge Accounting should be the simple answer to this but tens of thousands of pages of US GAAP and IASB interpretations make it far from simple and can leave the average CFO who has little background in Price Risk Management so confused he often elects not to use Hedge Accounting methods in the published accounts.

So let’s start from scratch and map out some basic measures that your managers should be receiving from your recording and reporting systems:

1. Cash Flow Risk. To get an even monthly cash flow in your business, revenue from sales is supposed to match the cash outflow from replacement raw materials. If metal volumes or prices are mismatched in that month, hedging is supposed to offset that mismatch with an equal and opposite cash flow from the hedge settlements. However, metal cash flow from sales and purchases gets buried inside product cash flow in your accounting system, so in order for you to measure combined financial impact you must pull out reports which extract the metal element in commercial cash flow and compare it with the offsetting hedge settlements. This will then allow you to track hedge efficiency and financial gain/loss from the overall net mismatch, not just payments to and from brokers – a combined metal pricing model.
   
   To manage your business effectively you need also to forecast this combined cash flow impact for metal under common conditions. This means the same price and volume inputs must feed the commercial and the hedge models. In order to rectify negative cash flow imbalances and staunch losses, you need to know which transactions, which customers or suppliers, and which plants are causing them. This means you have to link hedges with commercial deals in your recording system so it can aggregate the mismatches in whatever vertical you need in order to provide management with the incentive and tools for change.

2. Asset Valuation Risk. Accounting rules require metal stock-at-risk (priced unsold inventory of metal units in all forms) to be marked to the lower of cost or market and any unrealized valuation loss must be charged to income. Valuation losses, being transitory, are less important than cash losses, but many companies hedge stock-at-risk to offset this re-valuation impact and neutralize the effect of price change on the income statement. If you hedge this risk you must have the metrics to measure monthly changes in stock-at-risk – not necessarily the same as physical inventory – and the monetary value of the valuation change. You can then compare this in management reports with the unrealized hedge valuation gains which your accounting rules will oblige you to report. Only by having both reports can you be sure you are managing the combined exposure effectively.

3. Overall Exposure. We all have a one-dimensional sense of what is the risk in holding a $1M position in say Apple stock. Aluminum people have a similar sense about a 1000 ton long aluminum position. A combined commercial/hedge exposure is, however, much more complex. Someone once said that one transaction is a position, whereas two or more transactions are a book. Book metrics are affected by partial offsets and maturity differences, and the non-linear impacts of market change – much too complicated for a one-dimensional view.
   
   Three types of exposure measurement are helpful to a metal manufacturer for assessing overall price risk:
   • A netted strip of priced tonnage commitments for separate forward maturities, with commercial and hedge positions combined. This is closest to the one dimensional picture we naturally have a gut understanding for – how long or short am I overall?
   • The same strip with unrealized gains marked at the current market – a snapshot of current exposure which puts the picture in financial terms
   • The same mark-to-market strip with price sensitivity analysis for different market circumstances – the famous Value-at-Risk model which banks use is a variant of this – how much could I lose if the market goes pear-shaped?

Many companies use one or more of these risk metrics to report a simplified view of overall exposure to senior management, to ensure that risk management is operating within the risk appetite of the company. The corollary question of how you determine and quantify risk appetite is one for another day. All we know for sure is that the standard boardroom answers, zero risk or, I will know it when I see it, are neither practical nor helpful. You have to have a quantifiable appetite for risk and a willingness to express it.

4. Risk Slippage. The above metrics are all based on the concept of exposure snapshots which assume that transactions, once agreed, are locked in stone. While this may be almost true for financial hedges it is clearly not true for commercial deals. Cancellations, deferrals, increases, over/under-shipments of hedged orders are the reality of a manufacturer’s existence and a more dynamic set of metrics are needed to capture and minimize the financial impact of these factors on a hedged book of business. The cumulative effect of being over- or under-hedged can create losses greater than being unhedged in some circumstance and in order to stop it or correct for it you first have to identify it.
   
   The secret to slippage metrics is to ensure that the risk system provides a link between commercial order and hedge, and also between commercial order and final shipped quantity. With that you can create a suite of reports which cover the following slippage factors stated in both volume and mark-to-market gain-loss terms and sliced into whatever verticals you need: under/over-hedges: under/over-shipments: advanced/delayed shipments contango/backwardation cost; cancellations. Typically, sales is the primary focus but significant slippage occurs on the supply side too.

Clearly these metrics are not possible on the back of an envelope – or just from the Risk Manager’s spreadsheet of broker commitments. Price and volume data from orders, hedges, shipments and inventories needs to be collected, organized by customer, supplier, plant and profit centre verticals, and summarized in a risk context. To achieve this effectively you need two things – a robust risk system to generate the measurements and expert advice to organize and interpret them.

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