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Commodity A manual of hedging price risk for corporates Commodity Price | A manual of hedging commodity price risk for corporates

Contents

1. Introduction 04

2. Commodity Price Risk – An Overview 10

3. How do Corporates Address Commodity Price Risk? 16

4. What is Commodity Price Risk Hedging? 20

5. Methodology of Hedging Commodity Price Risk 24

6. Using Futures and Options to Commodity Price Risk 30

7. Benefits of Hedging Commodity Price Risk 34

8. Understanding Hedge 36

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1. Introduction Figure 1: A typical risk universe of a corporate as part of the enterprise risk management framework Strategic Operations Compliance Financial

Emergence of Risk Management and instruments to manage or ‘hedge’ against •• Board Performance / •• and •• Management Fraud •• Rate Changes Corporate Treasury insurable or uninsurable began •• •• •• Foreign Exchange The origins of risk management pre-dates to be used – and went on to be widely •• Expectations Fluctuations the 1700s with the use of probability used from the 1980s. The wide-spread •• / Support •• theory to solve puzzles and its use was use of derivatives naturally to •• Third-Party Relationships Management •• Liability •• Commodity Price Fluctuations largely limited for theoretical purposes the formation of various international •• Strategic •• and •• Regulations – however, during World War II risk regulations of using derivatives with •• Visibility & •• Annual Budgeting & •• Transportation and •• Customs Regulations management began to be studied and financial developing Forecasting Capabilities •• Compliance and implemented for various purposes. internal risk management models and •• Cash Movement – •• Alliances and •• Recruiting and Retention Management Traditionally, risk management in the calculation measures to protect Domestic & Cross-Border •• IT / Access place was always associated themselves from unanticipated risks and •• Accounting, Reporting and •• •• Funding Abilities with the use of to protect reduce regulatory capital. •• Natural Events Disclosure •• Liquidity Concentration institutions and individuals from bearing •• Macro-Economic Factors •• Geopolitical Events losses associated with accidents. •• At the same time, in the corporate •• Socio – Political Events •• , Plant and Management space as well, the of risk •• Employee Equipment However, from the 1950s, there were management became essential with •• Insurance •• Scalability other forms of risk management that the emergence of the enterprise risk •• Growth •• Management emerged as alternatives to insurance management framework – a framework •• Management Information •• – especially when insurance coverage that helps identify the various risks •• became costly and did not cover the risk affecting the (see figure 1) •• Environment exposure expected by the institutions. across its and operations and •• Environment / Health and Modern risk management practices measures and to address, mitigate Safety began to emerge around 1955 and in and monitor its impact on the institution •• / the , the use of derivatives as

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At many of the enterprise risk Figure 2: An illustration of the typical roles of the treasury department of a corporate –– -to-actual – which •• Commodity price fluctuations that The objective of the financial management meetings, may especially have a significant may affect the price of the commodity management function of a corporate management became an important impact on the profitability of an entity procured, maintained as inventory (raw treasury is to “ensure adequate discussion point at the that is either significantly dependent material or finished ) or sold to liquidity” to the business and level due risk on from overseas overseas parties or even on domestic functions either through cash or through to the emergence of additional risks management suppliers or selling goods to transactions – where the reference the utilization of term or term upon expanding business into new overseas buyers price of the commodity is affected by debt facilities - and the optimization of , establishing trade relations price fluctuations. the cost of financing by deploying surplus with overseas buyers and suppliers ––Foreign translation with funds in those instruments and managing liquidity and cost of respect to of financial that are permitted as per the risk appetite debt through effective funding and performance – limited to entities of the entity. Commodity investment strategies. Accordingly since Foreign Financial risk having subsidiaries outside of its price risk the late 1980s, several corporates began exchange risk management country of domicile to establish a dedicated unit separate management management from the traditional financial & accounts Figure 3: Key Components of the Financial Risk Management Lifecycle department - which would manage these financial risks and supply chain costs for the institution – this would be known as Risk Appetite the treasury department for a corporate. Risk Management Strategy An Overview of Corporate Treasury Risk Management Treasury management activities may Treasury Risk be distinctly divided between the Exposure Exposure Hedging Management mitigation/ financial risk managementand identification/ aggregation/ transaction performance financial recognition consolidation execution assessment functions respectively as highlighted in figure 2 below.

The objective of the financial risk Risk Management Governance management function of a corporate treasury is to “protect and preserve” Risk Operating Model the generated from the underlying business against external market forces Financial such as: Cash & liquidity supply chain Investment •• Changes in the interest rates in the management management management domestic or overseas geographies which may have an adverse impact on the interest charges on the existing domestic or foreign currency facilities undertaken by the group or its entities Debt management •• Foreign currency movements that may impact an entity in the following ways: ––Gain/ loss on foreign exchange transaction within its trade cycle – mainly due to the fluctuation in currency movements resulting from the timing difference on recognizing the payable/ receivable for import/ export to actually paying/ receiving the foreign exchange amount

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Components of the Financial Risk controls established for monitoring and used here include ‘gross exposure’ Management Lifecycle flagging instances of potential breaches which is the total value of exposures to The most important element with to the risk management strategy and a particular financial risk and respect to risk management to establish most importantly, the information in the . For example: total and assess the “Risk Appetite” of required to measure, monitor and value of foreign currency imports the entity. As per the Institute of Risk the effectiveness of the risk management of bauxite in case of an Management, risk appetite can be strategy to the Board of Directors and manufacturer. Another term used here defined as the ‘the amount and type senior management of the entity. is ‘net exposure’ which amounts to the of risk that an organisation is willing total value of exposures to a particular to take in to meet their strategic Keeping the above pillars in mind, financial risk after considering the objectives’. It establishes the tolerance a typical financial risk management offsetting impact of the same set that the Board of Directors is willing to lifecycle involves the following of exposures. For example: the net accept with respect to the impact of risk -steps: exposure to USD for an entity that on the entity’s top-line (i.e. ) and imports ore and exports copper •• Exposure identification and bottom-line (i.e. EBITDA). Typically, the wires will be the total value of imports recognition – To assess which elements risk appetite of an entity is established in USD adjusted against the total value of the business value chain of the as part of the enterprise risk of exports in USD at a certain entity is affected by the specific area of management framework – based on period of settling the / receipt financial risk i.e. interest rate changes, which the financial risk management of USD. commodity price or foreign currency strategy can be established.Upon fluctuations. This helps establish the •• Hedging transaction execution – establishing the risk appetite, the “Risk transactional information within the Once the total value of exposure to a Management Strategy” is the or value chain that is exposed to the financial risk has been ascertained, the strategic established for achieving specific financial risk. For example, in corporate treasury identifies a financial the objectives within the boundaries of case of a that’s instrument that can be used to ‘hedge’ the risk appetite of the entity established primarily an importer of raw materials, or offset the impact of the exposure by the Board of Directors. In case of financial risk exposure would include to the financial risk. The execution financial risk management, the risk the following: cycle typically involves entering into management strategy encompasses ––Foreign currency fluctuations a contract with a financial the strategic plan to address the afore- between the currency of purchase counterparty (either an exchange or a mentioned financial risks affecting the (i.e. foreign currency) and currency ) and settling the contract upon entity based on the level of impact it has of (i.e. INR conversion) maturity of the contract. on the Company’s financial performance. with respect to the time of obtaining •• Risk mitigation/ performance the for settlement up to With the risk appetite and risk assessment – This is the most the time of actually making the management strategy established for important element of the financial import payment financial risk management, the life- risk management lifecycle as this ––Commodity price fluctuation with cycle cannot be established without assessment demonstrates the degree respect to the commodity price having an effective “Risk Management of success of the implementation of at the time of structuring the Governance” by way of oversight by the the financial risk management strategy purchase order till the time of necessary senior management and Board based on the manner and level of receiving the L/C or invoice (as per of Directors of the entity coupled with meeting the desired financial risk the purchasing terms) , guidelines and mandates which management objective. ––Interest rate fluctuations with respect have been established for executing the to the foreign currency financing risk management strategy within the The next sections of this manual focus on undertaken for the import purchase appetite established by the entity’s Board applying the financial risk management like the LIBOR rate at the time of of Directors. elements to address commodity price receiving the borrowing to the risk – which has become a significant interest rate at the time of repayment The execution of the risk management focus area within the field of financial risk (assuming that the rate of interest is strategy depends on the manner in management and the manner in which floating and not fixed) which the “Risk Operating Model” has the derivative instruments provided by been established within the entity i.e. •• Exposure aggregation and commodity derivative exchanges can help processes for executing the strategy consolidation – The combined address a corporate’s commodity price (manual or automated), responsibilities transaction value that is exposed to risk issues. and activities thrusted on the personnel, the specific financial risk. Key terms

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Origins of Commodity Price Risk1 The evolution of exchange trading 2. Commodity Price The roots of management derivative for bulk go back to the ancient times. Commercial revolved around two important transactions in the early markets often elements: enhanced of involved a sale agreement between two the transactions and the emergence Risk – An Overview parties that were sometimes structured of speculative trading. Both these as a with various developments are usually connected features/ options on the agreement. with the increasing concentration of The contract could vary from loosely commercial activity, initially at the large What is a Commodity? What is Commodity Price Risk? structured between two parties to a medieval market fairs and, later, on the If we look at the legal definition of a Commodity price risk is the financial risk formal and notarized agreement based bourses and exchanges. Securitization commodity, it is defined as ‘a tangible on an entity’s financial performance/ on established rules and even . of bulk commodity transactions was item that may be bought or sold; profitability upon fluctuations in the Unstated terms and conditions of such facilitated by applying trading methods something produced for ’. of commodities that are out of agreements were often governed by that had been in use for centuries in the Therefore, commodities are considered the control of the entity since they are merchant convention. An agreement market for bills of exchange. to be marketable goods or wares, such as primarily driven by external market for a future sale would typically have a raw or partially processed materials, forces. Sharp fluctuations in commodity provision that would permit the purchaser One of the first examples of exchange products, or even jewellery. Intangibles, prices are creating significant business to refuse delivery if the delivered goods trading in commodities in a crude form such as human labour, services, or challenges that can affect were found to be of inadequate emerged in Antwerp during the second marketing & advertising, are typically not costs, , earnings and when compared to the original sample. half of the 16th century. The development considered to be commodities. availability. This price As reflected in notarial protests stretching of the Antwerp makes it imperative for an entity to back to ancient times, disagreement over provided sufficient liquidity to support manage the impact of commodity what constituted satisfactory delivery was the development of trading in “to arrive” price fluctuations across its value chain a common occurrence. contracts associated with the rapid to effectively manage its financial expansion of seaborne trade during performance and profitability. the period.

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In the 1840s, in the United States Price Discovery in Commodity Markets Figure 4: An illustration of price discovery in crude oil of America had become a commercial Price discovery is a process of Crude oil future price movements (Rs/b arr el) centre with railroad and telegraph lines determining the price of a specific connecting it with the eastern part commodity through basic supply and 4100.00 of the USA. Around this same time, demand factors prevalent in the market 3900.00 the McCormick reaper was invented place. The process of price discovery 3700.00 which eventually lead to higher depends on several interrelated 3500.00 production. Midwest American farmers factors such as market structure 3300.00 came to Chicago to sell their wheat to (such as number, size, location, and dealers who, in turn, shipped it all over competitiveness of buyers and sellers), 3100.00 the country. Unfortunately, at the time, market information (including amount, 2900.00 the had few storage facilities and timeliness, and reliability of information), 2700.00 no established procedures either for market behaviour (procurement/ 2500.00 weighing the or for grading it. In and pricing methods), global linkages 23-Jan-17 23-Feb-17 23-Mar-17 23-Apr-17 23-May-17 23-Jun-17 short, the farmer was often at the mercy and prevalence of futures markets or of the dealer. alternate risk management instruments. SpotPrice MCX future price NYMEX future price(Rs)

Then in 1848, a central place was Physical markets in are generally The price discovery approach at also a “light” and sweet crude oil with established in Chicago where farmers considered to be fragmented and Indian commodity exchanges have API gravity of 38.3 degrees and about and dealers could meet to deal in "spot" impacted by information asymmetries demonstrated their ability to align with 0.37 percent of sulphur. These qualities grain - that is, to exchange cash for and instances of intentional external the physical market prices as well as determine the weight of the liquid and immediate delivery of wheat. This central influences leading to greater price with international commodity prices, the costs associated. place was known as the ‘Chicago Board discovery inefficiencies. However, especially where a ‘price taker’ of Trade’ or ‘CBOT’. The , prices discovered in the commodities (see figure 4). Through price discovery / Reference Prices in as we know it today, evolved at the CBOT exchange market are more efficient due at national and international levels, Commodity Markets as farmers (sellers) and dealers (buyers) to where information flows substantial benefits have been obtained In the commodities markets, a began to commit to future exchanges of and assimilation are instantaneous and where market participants are able to benchmark is defined as an external grain for cash. For instance, the farmer more importantly, reliable. benchmark prices effectively with the reference price (i.e. outside of the would agree with the dealer on a price available commodity price and evaluate control of the contracting parties) that to deliver to him 5,000 bushels of wheat Trading by participants from across their purpose in the business value chain. are acceptable to both the buyer and at the end of June. The bargain suited the commodity ecosystem on a seller to be used directly or as a base for both parties. The farmer knew how much commodity exchange encourages The price of a commodity is also establishing the agreed price in he would be paid for his wheat, and transparency by leading the market characterized by various other factors the contract. the dealer knew his costs in advance. price of the commodity close to its such as quality, region, delivery routes, The two parties may have exchanged a ‘’. This enables geographical disparities, transportation Crucially, for a benchmark to be written contract to this effect and even and to develop effective pricing structure etc. For example, in recognised and adopted, it needs to a small amount of representing a hedging strategies. Such price signals are its natural state, crude oil ranges in reflect actual prices being agreed/ traded "guarantee” which was facilitated by essential for firms to take decisions on density, consistency and colour. This is across the marketplace. Fluctuations in the CBOT. production, marketing, and processing due to the fact that oil from different commodity prices most often has a direct of commodities, for example: farmers geographical locations will naturally have impact on the structured margins i.e. In 1864, the CBOT listed the first ever on expected returns among competing its own unique . Approximately profitability of an entity. Where pricing standardized "exchange traded" forward crops, small and medium enterprises 160 types of crude oil are traded in the benchmarks are transparent and similar contracts, which were called futures and large corporates about the possible physical market and exchanges together benchmarks are available in derivative contracts. In 1919, the Chicago future trends in relation to their - which vary in characteristics and quality. markets, commodity price risk may be and Egg Board - a spin-off of the CBOT, exposures, as well as consuming groups (‘WTI’) and managed through hedging the exposures. was reorganized to enable member such as importers/ exporters/ traders/ Brent are two crude oil markers which Additionally, domestic paper markets traders to allow future trading, and its consumers as to what will be the likely are either traded as per their quoted may base the benchmark prices based name was changed to Chicago Mercantile prices in the near future. prices or whose prices form the basis on internationally available benchmarks, Exchange (CME). This gave rise to the of price or ‘proxy’ for other crude oils. with due care on the use of conversion to global commodity futures and derivative WTI is a light crude with an API gravity INR and the metrics considered markets as we know today. of 39.6 degrees and contains about 0.24 in the domestic markets. The table

percent of sulphur, marking it as “sweet” below provides a sample of benchmark crude. In contrast, Brent is a combination physical/ paper prices typically used by of crude oils from 15 different oil fields commodity players and exchanges. in the Brent and North Sea areas. It is

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An example: SNo Commodity Group Traded global benchmarks Features of traded domestic benchmarks

1 Crude oil Brent, Platt’s Dubai, WTI Indian crude oil futures benchmarked to CME WTI Crude Oil prices Domestic jewellery manufacturer 1. Value chain 2 Henry Hub, JCC Indian Natural gas futures benchmarked to CME Henry Hub prices

3 Copper LME, COMEX Indian copper futures benchmarked to CME Copper prices. Pricing of gold for sale to Domestic pricing based on import parity pricing linked to LME. Purchase of gold Processing of across from Local bullion Full payment made 4 Aluminum LME Indian aluminum futures benchmarked to LME Aluminium prices. gold bars and the showroom Collections from dealer by fixing to the supplier at Domestic pricing based on import parity pricing linked to LME. manufacturing network based on customers across price derived from the time of taking of ornaments/ local market linked the showrooms 5 LME Indian zinc futures benchmarked to LME Zinc prices. international gold delivery of gold bars jewellery price derived from Domestic pricing based on import parity pricing linked to LME. benchmark international gold 6 Lead LME Indian lead futures benchmarked to LME Lead prices. benchmark Domestic pricing based on import parity pricing linked to LME.

7 LME Indian nickel futures benchmarked to LME prices. Domestic pricing based on import parity pricing linked to LME. 2. Financial impact on commodity price movement 8 Crude BMD Indian CPO futures are highly correlated with international benchmarks like BMD SNo Price Impact Movement 9 ICE - US Indian cotton (29 mm) futures have a high correlation with Indian Inventory Impact Sales Purchasing Earnings physical market prices 1 Fall in Higher cost of inventory Reduced sales values due Increase in purchasing Net realizable value is 10 Gold CME Group (COMEX), LBMA Indian gold futures bear strong correlation with COMEX prices, as also commodity which would lead to a to lower price – which power leading to higher below cost and sales Indian physical market prices price constraint in . impacts profitability volumes purchased realizes at lower value 11 CME Group (COMEX) Indian silver futures bear strong correlation with COMEX prices, as also thereby reducing Indian physical market prices earnings 2 Rise in Lower cost of inventory Increased sales values Decrease in purchasing Net realizable value is commodity which would lead to due to higher price power above cost and sales Impact of Commodity Price •• Affect inventory management solutions price increase in cash flow realizes at same or higher Movements on Revenue and as there is a direct impact on earnings value thereby increasing Profitability in case of fall in the value of inventory. earnings Volatility in commodity prices can impact Inventory is valued at cost or net different players differently depending realizable value whichever is lower. on where they lie on the value chain. Accordingly, where net realizable value Profitability of these players is also falls below cost, there is a real impact determined basis the variant of the to cash flows i.e., sales will realize a commodity that the entity is dependent on lower value within the value chain. A rise in commodity prices can: A fall in commodity prices can: •• Increase sales revenue for producers •• Decrease sales revenue for producers, if demand is not impacted by the price potentially decreasing the value of the increase. This in turn can lead to an organisation, and/or lead to change in increase in the value of the business. business strategy •• Increase competition as producers •• Reduce or eliminate the viability of increase supply to benefit from price production — and primary increases and/or new entrants seek to producers may alter production levels take advantage of higher prices in response to lower prices •• Reduce profitability for •• Decrease input costs for businesses consuming such commodities (if the consuming such commodities, thus business is unable to pass on the cost potentially increasing profitability, increases in full), potentially reducing which in turn can lead to an increase in the value of the organisation value of the business

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rising commodity prices by ‘passing it derivatives markets as well as in the on to the customer on the finished commodity exchanges. The OTC markets 3. How do Corporates goods’. Alternatively, such corporates provide such corporates with the ability also tend to negotiate with their suppliers to customize the contract that best fits towards a fixed price agreement – which with the exposure profile of the Company becomes a difficult ordeal where the - which is not available in the exchange Address Commodity price discovery and benchmark prices market due to requirement of that commodity are transparent and of the standardisation of contracts. easily available to all market participants. Another proponent for participating in Similarly, corporates exposed on the the OTC market usually stems where Price Risk? sales side of the value chain structure the benchmark prices available in the pricing barriers or through stepped-price exchanges are not aligned to the price bands within the sales contract which act discovery procedure for procuring or Commodity price risk intrinsically is Within the chain, as an embedded derivative. Alternatively, selling the commodity by the corporate. the uncertainty faced by corporates corporates are faced with different types most corporates look towards hedging to source or sell a product at a price. of commodity risks including ‘inventory their sales should the commodity Example – A jewellery manufacturer The nature & type of commodity price price risk’ with the risk of falling prices, benchmark price be available to hedge risk varies from to industry. ‘’ which is the difference through a derivative instrument. A domestic bullion/ jewellery Every company procuring a certain in benchmark price of the physical manufacturer is involved in the industrial commodity will face the challenge of commodity and the derivative instrument Corporates on the global scale have process of refining & converting bullion effective price management. Depending used to hedge the commodity price, and evolved and today utilize the liquid bars into jewellery. The manufacturer is on the commodity, it can be treated as ‘ risk’ which for a producer is on benchmarks to trade on the exchange worried on the procurement price and a “procurement commodity risk” or the risk of falling prices, and consumers and hedge the commodity price risk sale of the domestic bullion. To manage “tradable commodity risk”. Procuring on rising prices. using derivative products. Exchange this exposure, the manufacturer may risk is more focused towards the physical traded derivatives has its advantages think of hedging the procured gold bars supply chain side of the business whereas Corporates exposed on the procurement of transparent pricing, standardised with hedging contracts that are available tradable risk is on the financial risk & side of the value chain initially assess contracts and no risk. To a large on exchanges such as MCX. This will help hedging of the business. the feasibility of reducing the impact of extent Indian corporates continue to the manufacturer reduce the volatility participate in the over-the-counter (‘OTC’) and optimize costs on the procurement

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side while passing on the cost of hedging and sale is arrived at, a net exposure to the customer. Secondly, for the sale approach can be adopted, which reduces price to be achieved on the jewellery the overall risk on the manufacturer with products - the manufacturer can hedge respect to bullion price fluctuations. Price this exposure with bullion futures or risk is therefore optimized by reducing options available from exchanges like the overall exposure using the net MCX. Given that the benchmark price exposure approach as well as the ability will be the same with small variations in of passing on the cost of hedging to the the way the end price for procurement customer at the time of sale.

Example: A natural gas marketing company

Domestic Procurement

Natural Gas marketing company

Imports

P1

Price risk arises when:

P1 (Natural gax benchmark + fixed spread)

As an example natural gas marketing approach to a combination of risk and cost companies these days structure their deals based approach for the corporates is the on a formula pricing to attain physical gas real game changer. Corporates manage in storages on a seasonal contract so they procurement pricing by ‘opportunistic can utilize the seasonal benefits of lower hedging’ on international and domestic prices and withdrawals at higher prices i.e. exchanges based on the management’s managing the procurement price of the view of the market and operate with physical gas being purchased. Hedging of pre-defined levels on open the total quantities on the exchanges are positions. Hedging instruments like then performed based on the company’s futures, and options play a big part risk appetite. in offsetting risk on commodity price fluctuations. Although cost management by fixing prices is an important driver to manage prices, such companies have started to focus more on risk management & hedging of these prices. The gradual shift from the above only cost managed

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Commodity Price Risk Hedging – Commodity Price Risk Hedging – Origins Methodology 4. What is Commodity Hedging comes in various forms. Early An example of Hedging using Options - U.S. commodity (grain) merchants concerns to ensure buyers and sellers A company needs to buy aluminium as a purchased the produce with a certain – the company is exposed Price Risk Hedging? fixed future price resulted in forming the to the risk of price increasing at a certain forward contracts market. This acted as future date i.e. commodity price risk on a hedging instrument. There concerns procurement. As a result, the company were still taking undue credit risks. The may decide to buy a plain vanilla call Hedging – A brief overview Hedging can be performed by taking a issue was resolved by the establishment to hedge this exposure for that Hedging is a method of strategically using long or short position against the or of the (CBOT) tenor. As the prices are rising, they have financial instruments to offset the risk of physical product. Long hedge position is in 1848 which provided a centralised to pay more for the aluminium raw any adverse price movements. Hedging a strategy taken by generally producers location for standard contracts to be material to the producer although this plays a crucial role in the industry today or manufacturers of the commodity to traded. This lead to the concept of loss is offset by the gain they will realise for proper risk management and to protect from the prices going up in future organised financial commodity hedging on the long call aluminium option. Overall protect . Companies are when they have to source the asset at and the futures market. impact will be purchasing aluminium assessed by and a future price, whereas short hedge at a certain price which the company on the basis of how strong their hedging is taken when you are already owning Since the advent of the exchange had envisaged. strategy is. Derivative instruments such the asset and have to protect from the and development of the as forwards, futures, swaps and options prices falling in future. In both cases the place for hedging In the commodity markets, some of are examples of some of the instruments hedge will offset the loss of rising & falling has grown immensely. Hedging has the financial instruments available used by companies to mitigate the risk markets and will protect the company become an important topic for overall as hedging instruments has been and hedge the physical positions/asset. from having diminished margins. risk management strategy of the summarized in figure 6. . Although hedging was the primary reason initially for development of trade, we have had speculators entering the market place. This has additionally fuelled liquidity and helped the grow. 20 21 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

Figure 6: Typical financial/ derivative instruments available to hedge commodity price risk. Future contracts are typically the Commodity Price Risk Hedging – Hedging – Parameters to Consider most widely used financial/ derivative instruments Markets Liquidity management and working Managing commodity price risk is capital are of paramount importance for unavoidable for companies who have corporates. A company’s to create a niche in this sector. Every becomes difficult to sustain when commodity/commodity group brings it depends largely on working capital. its unique challenges. For example Hence outlay of capital and cost of crude oil and products have hedging is one of the most important Managing commodity risks by hedging liquid benchmarks and products both in factors for corporates selecting these international and domestic exchanges, derivative products. whereas most petrochemicals don’t have developed global benchmarks. Another important point for corporates Essentially depending on the commodity, to consider is the payoff of the certain strategies need to be planned and hedging instrument. Depending on the executed to manage price risk. Most of compatibility of the commodity and the the commodities these days are traded magnitude of hedge payoff corporates in international exchanges like ICE, CME, usually select the product. NYMEX, and LME – while in India, many Fixed price commodities are traded in domestic Additionally, the liquidity of the traded swap/ Three way Zero cost Plain vanilla Basis swaps exchanges like the MCX. One can also derivative product becomes an important futures participations trade on the over-the-counter markets parameter for a corporate. A highly liquid contract using forward contracts either with product – that is a derivative product international or domestic counterparties. displaying significant trading volumes on the exchange will be cheaper and For Indian companies, the Reserve Bank easier to execute. Corporates will also of India (‘RBI’) has formulated certain look at domestic exchanges for similar regulatory guidelines through the Master liquid instruments. There are cost and no Direction reference no. RBI/FMRD/2016- currency risk advantages for corporates Hedging performed in an efficient way The company can hedge against any 17/31 and the FMRD Master Direction No. using domestic exchanges. can lead to real value addition to the price fluctuation by opting for a listed 1/2016-17. The guidelines for example company, but there are risks associated fixed price swap or futures contract. state that Indian companies cannot hedge Basis risk also becomes an important which should be carefully considered The fixed price swap/ futures contract commodities like gold, silver and consideration for corporates when they and monitored. Tenor of the hedge is an guarantees a fixed price of material (e.g. on international exchanges unless specific consider certain futures to hedge with. important part. Corporates should revise ) over a predetermined period approval has been obtained from the RBI. Paper based futures can differ to the the hedges closer to expiry. Liquidity and of time. The company locks in a fixed physical benchmark price on a difference transparency of the instrument being used price on a fixed of material Although international exchanges have in grade, so a fixed spread is created. for hedging is another. This will have an (e.g. metal in an automobile industry) highly liquid benchmarks, domestic effect on cost of hedging. over a predetermined period of time exchanges have risen in stature. For Finally, most paper based markets by purchasing a fixed price swap from example – the MCX provides hedging settle on a net basis, and at times this is Another example: For an automobile the OTC counter party or by taking long contracts for a variety of bullion, base based on price assessment rather than manufacturer - the material costs positions in futures on an exchange. , agro-commodities, and energy traded price, there could be convergence amount to greater than 50% of the The swap price will reference LME (other markets. Indian firms have also turned to risk vs the physical market. Significant company’s revenue. Pricing of material pricing benchmark used for physical local exchanges to hedge risks and take convergence risk can enhance basis risk costs is directly linked to fluctuations in pricing). At the end of each period, the advantage of cheaper costs compared to a point where the hedging program commodity prices. Therefore, one of the settlement price (as reported by LME) is with international exchanges. Also becomes unviable which are lesser when key objectives of this company would compared to the swap price when Indian companies participate in trading on established exchanges trading be to lock in prices for a commodity at a international exchanges, they additionally liquid commodity derivatives. pre-determined fixed price either through If the settlement price > the swap/ get exposed to currency fluctuation exchange based derivatives or by arriving futures price, hedging counter party risks. As a result, domestic exchanges at a fixed price procurement contract with pays company the difference between such as MCX provides contracts that the supplier – the latter being difficult the settlement price and the swap price. are denominated in rupees to enable to usually achieve especially where the However, if the settlement price < the market participants to focus on hedging underlying commodity price price, the company pays the hedging commodity risk only. is high. counter party the difference between the swap price and the settlement price.

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5. Methodology of Hedging Figure 7: Value chain of a gold jewellery manufacturer Commodity Price Risk A Purchase of gold from local bullion dealer by fixing price derived from international gold benchmark

Value chain analysis and stages of the Company to understand its value Full payment made to the supplier at the time of taking delivery of gold bars considering entering into a hedging chain with respect to its exposure to arrangement commodity price fluctuations i.e. on B Value chain analysis is typically defined the procurement and storage of its raw as ‘a process where a firm identifies its materials to the storage and sale of primary and support activities that add finished goods. value to its final product and then analyze Processing of gold bars and manufacturing of ornaments/ jewellery these activities to reduce costs, increase Taking the example of a domestic gold C profitability or increase differentiation’. jewellery manufacturer, as given above, However, in the case of commodity price the value chain can be summarized in the risk management, prior to undertaking following diagram: the hedging activities, it is important for Pricing of gold for sale to customers across the showroom network based on local market D linked price derived from international gold benchmark

E Collections from customers across the showrooms

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The above value chain explains that domestic market. However, the demand •• Sale of jewellery is mainly procurement of gold and sale of the Company sources its gold from for gold is highly price elastic leading done across the network of gold jewellery, in India, the Company local bullion dealers – where the price to difficulty in estimating demand and showrooms of the Company in the is required to use exchange based that is fixed at the time of procurement fixing of gold price. Moreover, fixing of domestic market derivatives such as futures and is derived from international gold price for gold sales is undertaken based options to hedge the gold price risk. benchmark prices – which is usually on local benchmarks that are derived •• The demand for gold is highly quoted by the from the international benchmark prices. Key considerations for hedging price elastic leading to difficulty in Association or ‘LBMA’. Therefore, this part of the value chain price risk estimating demand and fixing of analysis indicates that the procured gold The value chain analysis provides the gold price Let’s consider stages A to B – in this case has been priced in and now profitability summary of the need to hedge price risk – the price is fixed at the time of order with can only be realized if the fixed sale of however given regional market dynamics, 02. Pricing environment: the bullion dealer, therefore the Company gold is higher than the procured price of an additional step is required so as to does not face any exposure to commodity gold. As a result, the Company may have •• Gold price fixing of purchases takes assess the ability to hedge the price risk price fluctuations till the time it fulfils a potential need to enter into another place on the basis of international of the commodity under considerations. the payment for the purchase. Another hedge during the sale order time to benchmarks Key considerations for this assessment inference that can be made is that usually protect itself from the risk of depreciated include: •• Fixing of price for gold sales this would be a relatively low lead time prices of gold. 01. Available markets/ indices: Trading is undertaken based on local from order to payment – typically a cash markets (exchange-based/ over-the- benchmarks that are also usually and carry arrangement. However, if If we consider the stages D to E – this has counter) available for hedging the derived from international there was a case where the price at the the final impact based on the demand price risk of the commodity in India benchmarks time of order was indicative for purchase exhibited by the end customers. The sale or in special cases, in international and not fixed, then the Company would of jewellery will be based on the date on •• The Company therefore operates markets as well as the feasibility have been exposed to commodity price which the customer decides to purchase in a pricing environment where it is of each market to complement the fluctuation until the time of fulfilling the the jewellery – hence there may be a lag not possible to avoid the exposure exposure profile of the Company for payment for that purchase – and if the at the time of maintaining the priced in to commodity price risk hedge consideration. price of gold appreciated from order sale of jewellery at the showroom to the to payment, that would entail a higher price at which the customer ultimately 03. Business impact: 02. Hedging instruments: Hedging purchase price onto the customer. purchases the jewellery. However, instruments available within each •• The difference in timing of fixing Therefore this part of the value chain given the difficulty in estimating the of the identified trading markets gold prices for purchases and for analysis indicates the potential need time of purchase of customers, hedging (futures/ options/ swaps etc...) as sales to a risk on business to consider a hedging arrangement to tenor may not be extended hence as well as the feasibility of each hedging margins for the Company on protect the Company from gold price a mitigation strategy, the Company instrument to complement the of in fluctuations. focuses on streamlining its inventory exposure profile of the Company for gold prices and arrangements so as hedge consideration. Let’s consider stages B to C – in this case, to minimize the lead time of supplying •• The Company may not be able to the Company has procured its gold and the showrooms with the priced in gold successfully pass-on this market 03. Exchange trading volumes: Trading stored it in the vault until it’s time for jewellery up to the time of purchase by price risk to its customers since the volumes prevalent in such hedging processing and converting the gold bars the end customer. pricing and business environment is instruments at the identified into ornaments or jewellery. The time highly competitive exchange trading markets so as to for storage in its inventory continues Therefore, value chain analysis assess the Company’s exposure vis-à- •• Thus, the Company is exposed to expose the Company to gold price summarizes the following: vis liquidity and risks thereon. to the volatility in the gold prices fluctuations therefore having an impact 01. Business value chain: which can significantly erode the on the inventory value of procured gold. 04. Pricing considerations: Price •• The Company is involved profitability of Company Therefore this part of the value chain discovery methodology and quality in processing of gold and analysis indicates the potential need of the underlying commodity of the manufacturing of jewellery and 04. Price risk considerations: to evaluate the tenor of the hedging derivative offered by the exchange directly selling the finished products contract to protect itself from gold price •• The Company may be required to along with the trading units so as through its showrooms. fluctuations. hedge the prices of gold to be sold to align with the Company’s pricing •• The Company procures gold on at commercially acceptable levels mechanism and benchmark price Let’s consider stages C to D - Sale of cash and carry basis from local without creating additional basis and •• Given that the Company cannot jewellery will typically be done across bullion dealers where the price is other risks. alter any of the business dynamics the distribution network of also derived from international around the physical business, i.e.; showrooms of the Company in the benchmarks

26 27 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

05. Margin requirements: Margin Lifecycle of a typical commodity price SNo Commodity price risk & hedging stage Key activities requirements pertaining to initial risk and hedging framework margin and variation margins (for After assessing the business value chain 1 Exposure collation and aggregation Identification and recognition of commodity exposures based on type for example: SPAN based margin v/s to arrive at the price risk considerations procurement or sales budgeting and maturity profile of the procurement/ sales percentage of contract value for and after assessing the considerations 2 Risk quantification and assessment of Quantification of risk based pricing and market movements and assessment of trading at the MCX) based on the for hedging the underlying commodity potential impact factors affecting off-set between hedges and underlying exposure contract size and volatility of the that’s causing the price risk issue to the prices of the underlying commodity Company, the next stage effectively 3 Decision support & setting hedge ratios Limits to market operations and monitoring for the same and setting of the hedge under consideration. forms the main part of the commodity ratios (Hedge ratio = Hedge value/ Exposure value) based on risk appetite price risk and hedging framework. 4 Price fixing arrangements Lock-in of purchase/ sales price to minimize impact on inventory value and 06. Regulatory considerations: structured margins Regulatory guidelines applicable The following diagram provides the for undertaking hedges for the summary of the key stages of the 5 Re-balancing instrument mix Decision support to re-balance hedging instruments and pricing options based on selected hedge market (such as any commodity price risk and hedging market movements and hedging strategy commodity exchange) and hedging framework. Each stage of this framework 6 Hedge transaction execution Entering into hedge transaction using exchange-traded futures/ options (or instrument/s. in this diagram is explained in the OTC hedging instruments), establishing hedge rationale & basic documentation subsequent table. support and linking hedges to underlying exposures

7 P/L and MTM computation Mark to market (i.e. market value of hedge and exposure on a specific date) of hedges & exposures to track performance on an ongoing basis along with & loss computations to assess extent of off-set from underlying and hedge positions Figure 8: The stages of the commodity price risk and hedging framework 8 Hedge performance assessment Assess hedge performance based on degree of offset achieved on the underlying exposure along with other performance and risk indicators

Key documentation requirements for •• Risk management principles of the Risk quantification Price fixing Hedge transaction Hedge performance executing the commodity price risk Company i.e. the salient philosophy and assessment of arrangements execution assessment and hedging framework and guidelines for facilitating the potential impact To enable the execution of the commodity commodity hedging activities price risk and hedging framework, the •• Authorized markets and Company is required to maintain the hedging instruments i.e. the following documentations: acceptable hedging markets (ex. 01. Commodity price risk – The List of exchanges) and hedging commodity price risk policy provides instruments (ex. Futures and 1 2 3 4 5 6 7 8 the principles and guidelines for the options) that the Company has Company to facilitate its commodity authorized to undertake in its hedging activities. This is usually hedging activities signed-off by the Board of Directors of the Company. Salient features of 02. Standard operating procedures – the policy include: Key operating guidelines for Exposure collation Decision support & Re-balancing P/L & MTM •• The risk appetite of the Company undertaking the hedging activities and aggregation setting hedge ratios instrument/ mix computation with respect to commodity price risk which are supplemented with the i.e. the degree of risk the Company internal controls maintained within is willing to expose its business the Company. margins to commodity fluctuations – this also determines the required 03. Reporting framework – MIS & hedge ratio to be maintained by to be provided to various the Company levels of the Company’s management with respect to the exposures, hedges, hedge performance and other aspects required from the Company’s commodity price risk and hedging framework.

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6. Using Futures and Figure 9: Typical pay-off structure of a futures contract Net Price

Options to Hedge Example: A Company that sells finished goods where Company receives the underlying commodity Difference is linked to a specific pricing Commodity Price Risk benchmark – and enters Company into a futures contract pays difference

Futures contract commodity exchanges can be physically Swap/ Futures contract Price A futures contract is a legal agreement, settled upon contract maturity or is cash generally prescribed by a futures settled (as mandated by the commodity Market Price exchange, to buy or sell a particular exchange). The pay-off structure is linear commodity or at a with respect to the market price at the predetermined price at a specified time in time of settlement. Opportunity Gain Opportunity Loss Hedged Unhedged the future. Futures contract executed in

30 31 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

Example: A gold manufacturer are traded. For instance, the contract Net Price Put options can be specifications of a typical gold futures •• The Company locks in a fixed price compared to buying contract in MCX can be referred to the on a fixed volume of gold over a insurance. The Company following link: https://www.mcxindia. com/ predetermined period of time by is protected against fall in products/bullion/gold taking short positions in futures on the price, but participate fully commodity exchange like MCX. when price is rising Plain vanilla option contract Company •• The futures price of the MCX futures An options contract is an agreement receives difference contract reflects the Indian spot price, between a buyer and seller that gives the Swap Price } Premium paid which typically has a high correlation purchaser of the option the right to buy with COMEX Gold futures as India is or sell a particular asset at a later date a ‘price taker’ for Gold. At the end of at an agreed upon price. Typically the each period, the settlement price (as underlying of an options contract listed on Buy Put Strike reported by MCX) is compared to the an exchange will be the futures contract Market Price future price. for the same commodity. Option contracts are also termed as call and put options Opportunity Gain Hedged Unhedged •• If the settlement price < the futures based on the position of the market price, the Company gains the difference participant when undertaking the contract. between the future price and the settlement price. Example: A gold manufacturer Call option – A call option is an option •• If the settlement price > the futures contract between two parties where the •• A available in MCX effectively price, the Company is at a loss on the buyer of the call option earns a right (not creates a floor price in exchange for an difference between the settlement an obligation) to the option to option premium. This premium reflects price and the futures price. buy a particular asset from the call option the likelihood that the option will be seller for a stipulated period of time. Once exercised. In other words, the farther Key advantages the buyer exercises his option, the seller the is from trading levels, has no other choice than to sell the asset the lower the amount of premium paid •• Exchange traded hence no at the strike price at which it was originally upfront. counterparty risk exposure agreed. The buyer expects the price to •• The put option will reference to the •• Standardized contract applicable to all increase and thus earns capital profits. underlying MCX gold futures price. market participants Put option – A put option is an option •• At the end of each period, the price •• Transparent pricing as per exchange where the buyer of the put option earns of the underlying is compared to the quotes a right (not an obligation) to exercise his option "strike" price. •• Contract can be closed out prior to its option to sell a particular asset to the •• If the price of underlying < the strike maturity put option seller for a stipulated period price, the Company can either square of time. Once the buyer of put exercises of the Options position and profit from Key disadvantages his option (before the date), rise in value of Option, as with the fall the seller of put has no other choice than •• of contract may not in gold prices, the premium for gold to purchase the asset at the strike price align well with the Company’s exposure put option will rise. Given that option at which it was originally agreed. The profile with respect to tenor of hedge contracts traded in India are primarily buyer of put expects the value of asset to European based options, on expiry of •• May create basis risk where there is a decrease so that he can purchase more the options, the put buyer can exercise difference in the pricing benchmark quantity at lower price. his option, which will result in creating a used in the future contract against sell position in the underlying futures at the pricing benchmark considered for Strike price is the pre-determined price at the ‘strike price’, which can be squared physical trade by the Company with its which the buyer and seller of an option off at the current market price, to suppliers/ customers agree on a contract or exercise a valid and realise profits.. This payment offsets unexpired option. While exercising a call •• Involves continuous monitoring on lower prices in the physical market. option, the option holder buys the asset margin maintenance from the seller, while in the case of a put •• If the settlement price > the strike price, option, the option holder sells the asset to the purchased option expires and is Contract specifications of commodity the seller. rendered worthless. But the Company derivative contracts can be found on the benefits from higher prices in the websites of the exchanges where they physical market.

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For those companies that are exposed to earlier is now moved away from the P/L the same pricing benchmarks on its costs thereby adding additional stability to 7. Benefits of Hedging and revenue side, using a net exposure the P/L volatility attributed to fluctuating approach in its hedging program, if commodity prices. However, it is essential done correctly, helps mitigate the overall that the hedge-exposure relationship is exposure to fluctuating commodity price based on offset and not on the same side. Commodity Price Risk with the net exposure being hedged – therefore additionally protecting that Cost benefits portion of the impact of the exposure Hedging the commodity price risk using Cash flow benefits One of the advantages of hedging from fluctuating commodity prices. exchange traded derivative contracts Working capital is the essence of any commodity price risk is the ability tends to lower the cost of hedging as business and managing cash flow is a to minimize cash flow fluctuations P/L offset and accounting benefits compared to undertaking an over-the- challenge for almost every company. attributed by commodity price The advent of Ind AS (as explained in counter derivative contract for the Business owners as a result stay vigilant movements. Hedging insulates the the subsequent section) has allowed for purpose of hedging – especially where in order to keep the business financially company from such volatile price Indian companies to realize the impact the traded derivative contract is highly viable. Fluctuating commodity prices movements, and is poised to stabilize on their hedges and exposures on the liquid. This is largely attributed to the especially on a significant part of cash flow volatility by creating an P/L thereby offsetting the impact on the lower spreads on the quoted derivative the value chain can cause cash flow offsetting impact in case of commodity P/L – which as a result helps the company prices as compared to the over-the- fluctuations in the business. Hence, price fluctuations – with the aim to to reduce P/L volatility attributed to counter market which do not require any forecasting and protecting future almost achieve a zero-sum game for the fluctuating commodity prices. additional negotiation (again as done cash flows become vitally important. commodity exposures covered under on the over-the-counter market) and Difficulties in liquidity as a result force that hedge. Furthermore, Ind AS allows for hedges the true cost is primarily attributed to the company to undertake short-term undertaken against highly probable margin maintenance. This is essential for financing arrangements to address the forecasted exposures – which are off those companies that do not have the liquidity deficit – which increases the items, to not have their necessary ability to pass on the costs of costs to the company. MTM impact realize on the P/L – till the commodity price fluctuation and hedges time this exposure is recognized as on to the customer – due to competition a balance sheet item. Therefore, the and other market pressures. lop-sided impact on hedges as done 34 35 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

exposure with the hedging instrument. Financial Instruments and Ind AS 113: Moreover, the ability of the offset on the Fair Value ), focus on 8. Understanding P/L was not necessarily achieved through is primarily on Ind the hedging programs leading to a wide AS 109 where a risk component of a difference between the cash flow impact non-financial item will be eligible as a v/s the accounting impact from the hedged item, provided it is “separately Hedge Accounting hedging program. identifiable and reliably measurable”. This criteria would generally be met if the risk Additionally, where hedges were taken component is contractually specified. on forecasted exposures, companies It is also possible that non-specified Hedging programs of companies have Until recently, under Indian GAAP, there were unable to showcase the offset as risk components meet the criteria in typically evolved with the dual objective wasn’t any comprehensive literature for the effect of change in the commodity/ some cases. Allowing a closer match of protection of cash flow margins and accounting for financial instruments. currency rates on the forecasted between the hedged risk and the hedging protection of reported earnings against While AS-13 Accounting for exposure did not show on the P/L being derivative has resulted in more common price volatility in financial statements. dealt with the accounting for investments an off-balance sheet item while the effect risk management strategies to qualify for Over the past few years, as the evolution in the financial statements and related of change in the commodity/ currency hedge accounting and therefore, lesser in accounting standards didn’t always disclosure requirements, it did not cover rates (or MTM) on the hedging instrument volatility (i.e., ineffectiveness) in profit keep pace with innovation in hedging the classification and measurement of had to be taken into P/L, especially in the or loss. strategies and financial instruments, the financial liabilities. While some other case of MTM loss – therefore creating a dual objectives of cash flow protection standards covered some other aspects lop-sided view on the profitability of Example – Contractually specified and reported earnings protection of financial statements such as AS-11 the Company. risk components - Entity P is a large tended to be at cross purpose. This led Effects of Changes in Foreign Exchange manufacturer with an extensive network to companies that structured hedging Rates covered certain foreign exchange Upon transition to the new accounting of and distribution outlets. strategies that focused on achieving contracts – however these requirements standards – Ind AS, with respect Fuel costs are significant. To reduce either one of the two objectives or at as per the Indian accounting standards to financial instruments (covering profit or loss volatility, the entity’s risk times wavering between these objectives. were never as robust as per the Ind AS 32: Financial Instruments: management strategy allows it to hedge As a result, confidence in International accounting standards. At Presentation, Ind AS 107: Financial a component of the fuel price risk using hedging programs was challenged at each that time, it was difficult to establish Instruments: Disclosures, Ind AS 109: futures and swaps for periods of up reporting date. the relation between the hedged item/

36 37 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

to three years. Entity P purchases fuel •• Link each commodity hedge to the Key disclosures for commodity ‘The Company uses various derivative under a five year contract which specifies commodity price risk strategy - Such price risk financial instruments such as interest the formula for diesel price per litre. linking has to be done at the inception Disclosures related to hedge accounting– rate swaps, currency swaps, forwards The amount of fuel to be purchased is of the hedge to prove intention With respect to disclosures under Ind & options and commodity contracts not specified but vehicles fill up diesel at inception. AS 107 for hedging the commodity price (such as futures and options) to mitigate as required. The volume used is billed risk in line with the Ind AS 109 accounting the risk of changes in interest rates, •• Each hedge should be earmarked as on a monthly basis. In this case, the standard, a company is typically required exchange rates and commodity prices. a cash flow or fair value hedge at the diesel price risk component is separately to disclose the following: Such derivative financial instruments inception of the hedge transaction. identifiable as it is contractually specified are initially recognised at fair value Cash flow hedges are those hedges and reliably measureable. Entity P Significant accounting policies – on the date on which a derivative where the underlying exposure is not can choose to apply Derivatives and Hedge Accounting contract is entered into and are also yet considered as a balance sheet accounting for the highly probable Hedge accounting activities are disclosed subsequently measured at fair value. item while fair value hedges are those forecast purchase of the first million litres in the significant accounting policies of Derivatives are carried as financial hedged where the underlying exposure of fuel during each calendar month. a listed company’s annual reports. The when the fair value is positive has already been considered as a following components enumerates the and as financial liabilities when the fair balance sheet item. It is important to Example – Non-contractually specified various aspects covered in the disclosure: value is negative. differentiate between the two kinds risk components - Entity Q purchases of hedge given that the accounting •• Brief insight on the hedging of a particular quality of specific Any gains or losses arising from treatment is different for the two. framework: For example, a company origin under a contract with the supplier. changes in the fair value of derivatives In case of cash flow hedges, the may provide an insight such as: The purchase price comprises (i) a are taken directly to Statement of differential of the mark-to-market of variable element that is linked to the Profit and Loss, except for the effective the hedges and exposures will not ‘At the inception of a hedge relationship, benchmark price for coffee which is of portion of cash flow hedges which is enter the P/L but under the ‘hedge the Company formally designates and a different grade/quality; and (ii) a fixed recognised in Other Comprehensive fluctuation reserve’ also wide known documents the hedge relationship spread to reflect the different quality Income and later to Statement of as ‘Other Comprehensive Income’. to which the Company wishes to that is being purchased. Entity Q enters Profit and Loss when the hedged item However, in case of fair value hedges, apply hedge accounting and the risk into coffee futures to hedge its exposure affects profit or loss or treated as the differential of the market-to-market management objective and strategy to variability in cash flows from the basis adjustment if a hedged forecast of hedges and exposures will need to for undertaking the hedge. The benchmark coffee price and designates transaction subsequently results in the be considered within the P/L of the documentation includes the Company’s it as the hedged item. However, the recognition of a non-financial assets or Company. risk management objective and strategy changes in the fixed spread relating to non-financial liability.’ for undertaking hedge, the hedging/ different quality would be excluded from •• All hedges are expected to be cash economic relationship, the hedged item the hedge relationship. flow hedges if they are taken against or transaction, the nature of the risk •• Explanation of the criteria for budgeted exposures or orders which being hedged, hedge ratio and how the recognizing the treatment of a hedge With the advent of Ind-AS and the ability do not reflect on the of accounts. entity will assess the effectiveness of as a cash flow and fair value hedge: of applying hedging accounting under the It is important as part of the hedge changes in the hedging instrument’s For example, the disclosure for an Ind AS 109 in a comprehensive manner, accounting strategy to clearly earmark fair value in offsetting the exposure to aluminium manufacturer may be: companies now have an opportunity what constitutes a cash flow exposure changes in the hedged item’s fair value to align their commodity price risk and a fair value exposure. or cash flows attributable to the hedged ‘Fair value hedge - Changes in the fair management strategy with reported •• The hedge documentation should risk. Such hedges are expected to be value of derivatives that are designated earnings. Additionally, companies also necessarily carry the deal rationale highly effective in achieving offsetting and qualify as fair value hedges are have an added opportunity for reducing for each deal. Hedge effectiveness changes in fair value or cash flows and recorded in the statement of profit hedging cost which had to be incurred testing is required to be performed to are assessed on an on-going basis to and loss, together with any changes to manage reported earnings. However, offset principle for hedging – which is determine that they actually have been in the fair value of the hedged item this will require companies to re-align left to the discretion of the company’s highly effective throughout the financial that are attributable to the hedged their existing hedging strategies with the auditors. Hedge effectiveness testing reporting periods for which they were risk. Hedge accounting is discontinued underlying fundamental business value shall be performed by assessing the designated. when the Company terminates the chain of the company. cash flow offset from hedges and hedging relationship, when the underlying exposures. The same hedging instrument expires or is sold, Accordingly the following principles •• Initial recognition and subsequent method is required to be consistently terminated, or exercised, or when it no are typically required to be adhered to measurement of financial followed irrespective of the hedging longer qualifies for hedge accounting.’ by a Company using the hedge instruments i.e. financial instruments strategy or type of instrument. accounting approach: used to hedge commodity, interest rate

and . For example,

the disclosure for an oil refiner may be:

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‘Cash flow hedge - The effective under Ind AS 109. A financial liability portion of changes in the fair value (or a part of a financial liability) is of derivatives that are designated derecognized from the Company's and qualify as cash flow hedges is Balance Sheet when the obligation recognised in other comprehensive specified in the contract is discharged income and accumulated under the or cancelled or expires. heading cash flow hedging reserve. The gain or loss relating to the Disclosures in Statutory Reports for ineffective portion is recognised listed companies immediately in the statement of profit As per the SEBI ( Obligations and and loss, and is included in the ‘other Disclosure Requirements) Regulations, gains and losses’ line item. Hedge 2015 (Notification dated September 2, accounting is discontinued when 2015) for commodity price risk, a the hedging instrument expires or listed company is required to disclose is sold, terminated, or exercised, or the following in their corporate when it no longer qualifies for hedge governance report: accounting. Any gain or loss recognised •• General shareholder information/ in other comprehensive income and other disclosures: Information accumulated in equity at that time on exposure of the company to remains in equity and is recognised commodity price risk and hedging when the forecast transaction is activities/ approach. For example, for a ultimately recognised in the statement jewellery manufacturer, the disclosure of profit and loss.’ of commodity price risk under the report may be: •• Re-classification of cash flow hedges to fair value hedges: For example, a ‘Disclosure of commodity price risks company may disclose the following: and commodity hedging activities: The Company uses financial derivative ‘Amounts previously recognised in instruments to manage risks associated other comprehensive income and with gold price fluctuations relating to accumulated in equity are reclassified highly probable forecasted transactions to the statement of profit and loss in and currency fluctuations relating the periods when the hedged item to certain firm commitments. The affects the statement of profit and Company has designated derivatives loss, in the same line as the recognised undertaken for hedging gold price hedged item. However, when the fluctuations as ‘cash flow’ hedges hedged forecast transaction results relating to highly probable forecasted in the recognition of a non-financial transactions.’ asset or a non-financial liability, the gains and losses previously recognised Risk Disclosures in other comprehensive income and A listed company also provides the accumulated in equity are transferred associated risk related disclosures from equity and included in the initial affecting the business performance measurement of the cost of the non- within its – in the Financial or non-financial liability Instruments section in the notes to accounts/ part of the report. In case of commodity price risk, •• De-recognition of financial a risk disclosure for companies having instruments: The Company significant exposure to commodity derecognizes a financial asset when price fluctuations will capture this as the contractual rights to the cash flows a component of ‘Market Risk’ – usually from the financial asset expire or it termed as ‘Price risk’ in their disclosure. transfers the financial asset and the

transfer qualifies for de-recognition

40 41 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

As per Ind AS 107, providing qualitative Qualitative disclosure disclosures in the context of quantitative ‘The Company is exposed to fluctuations disclosures enables users to link related in gold price (including fluctuations in disclosures and hence form an overall foreign currency) arising on purchase/ picture of the nature and extent of risks sale of gold. To manage the variability arising from financial instruments. The in cash flows, the Company enters interaction between qualitative and into derivative financial instruments quantitative disclosures contributes to to manage the risk associated with disclosure of information in a way that gold price fluctuations relating to better enables users to evaluate an all the highly probable forecasted entity’s exposure to risks. transactions. Such derivative financial instruments are primarily in the nature of future commodity contracts, forward •• Entities are required to disclose the commodity contracts and forward exposure to risk and how they arise as foreign exchange contracts. The risk well as the risk management objectives, management strategy against gold price policies and processes and methods fluctuation also includes procuring gold used to measure the risk as part of their on loan basis, with a flexibility to fix price Qualitative disclosures of gold at any time during the tenor of •• Entities are required to provide a the loan. As the value of the derivative summary of the quantitative data instrument generally changes in about its exposure to that risk at the response to the value of the hedged item, end of the reporting period based on the economic relationship is established. the information provided internally to the key management personnel of Quantitative disclosure the entity as part of their Quantitative Alternative 1: Exposure to one commodity disclosures Particulars Value* •• Additionally, where commodity price risk is a part of market risk, the risk Total exposure as on March 31, 20xx INR 5,000 cr disclosure may also include a sensitivity Sensitivity to net profit at 10% movement 16% analysis, such as value-at-risk, that reflects interdependencies between risk variables (ex. commodity prices Alternative 2: Exposure to two commodities and exchange rates) and uses it to manage financial risks – with respect to Particulars Value* its methods and limitations. Total exposure of commodity 1 as on March 31, 20xx INR 5,000 cr

For example – in the case of a jewellery Total exposure of commodity 2 as on March 31, 20xx INR 400 cr manufacturer having a significant Sensitivity of commodity 1 to net profit at 10% movement 16% exposure to gold price fluctuations, a typical disclosure will look like the Sensitivity of commodity 2 to net profit at 10% movement 5% following: Or Combined sensitivity of commodity 1 & 2 to net profit 14% (using value-at-risk) *Illustrative value for representative purposes only

42 ©MCX 2018. All rights reserved. No part of this document may be reproduced, or transmitted in any form, or by any means - electronic, mechanical, photocopying, recording, scanning, or otherwise - without explicit prior permission of MCX*.

Disclaimer: This document is made available for the limited purpose of creating awareness about the need and modalities of hedging against commodity price uncertainties using commodity derivatives. It is not intended as professional counsel or investment advice, and is not to be used as such. While MCX have made every effort to assure the accuracy, correctness and reliability of the information contained herein, any affirmation of fact contained in this documents shall not create an express or implied warranty that it is correct. This document is made available on the condition that errors or omissions shall not be made the basis for any claims, demands or cause of action. MCX or their employees, shall also not be liable for any damage or loss of any kind, howsoever caused as a result (direct or indirect) of the use of the information or data in this document.

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