Inflation has caught many companies off guard but it’s not too late to devise a hedging strategy or revisit the one you have to manage price volatility, Chatham Financial Managing Partner Amol Dhargalkar told CFO Dive.
“The V-shaped recovery that people were talking about [during the pandemic] didn’t quite take place in 2020 nearly to the degree that we saw at the beginning of 2021 as vaccinations took root,” said Dhargalkar, whose firm helps companies devise hedging programs and calculate the price of derivative instruments. “So, companies didn’t hedge a year ago, based on our experience, whereas today that’s a much higher priority and we’re having just so many conversations right now.”
The kind of risk you need to hedge against depends on the industry you’re in. Manufacturers are seeing increases in oil, metal and commodity prices, so they need to devise a plan for insuring against future increases in these areas if they don’t already have one.
This type of hedging tends to involve futures or options contract purchases, transactions complicated by the need to determine the market price and the markup that’s being hedged against.
“It’s trying to understand the bank’s cost of offering this product and a reasonable markup for my firm, my situation, my credit,” he said. “That’s particularly difficult because, unlike exchange traded derivatives, these tend to be customized products, traded on credit. Because you don’t post cash collateral, your counter-party is taking risk from the company that could default, go bankrupt.”
There are few options for companies wanting to get a handle on contract pricing other than working with consultants who have access to market data, unless they want to hire a banker to work for them or try to work collaboratively with other companies.
“If you hire a former banker onto your team that used to sell these products, he or she might have knowledge that could help benchmarking pricing,” he said. “If you could get together with your competitors and compare pricing that would be ideal but that, of course, is frowned upon and highly unlikely to occur.”
Cloud software risks
Cloud-based software companies, even though they don’t face the commodity or other input risks of a manufacturing company, need their own strategy to hedge against exchange rate or interest-rate risks.
The need to hedge is the case if they sell in multiple countries because of volatility in currency rates, but even if they only sell in the country they’re based in, say the United States, they might still need to hedge if they have development operations in another country.
“You could have a portion of your development costs denominated in a different currency,” he said. “It could be that you’re a cloud-based multinational where revenues are being denominated in a number of different currencies, based on your customer base.”
The good thing about exchange-rate risk is it tends to be more transparent than commodity price risk, but even here, knowing how to price derivative contracts and their markup can be difficult.
There tends to be two types of currency hedging risks, he said. There’s a short-term risk that involves receivables and payables, since those tend to operate on 30- or 60-day timeframes, and a long-term risk, sometimes called cash flow risk, that involves projected revenues and expenses, or the net of those two, over one or several quarters.
“If you look at most public technology companies that provide some form of cloud services, it would not be hard to find in their financials they’re doing some form of currency hedging,” he said.
Almost as important as the strategy is how you communicate it to investors, Dhargalkar said. The last thing you want to do is spend time on earnings or investor calls explaining why your balance sheet looks the way it does because of your hedges.
“If your program is small and your company is big, you can do things without having to explain them too much to investors, because it takes a very tiny portion of your financial results and line items,” he said. But if the programs are material, “you don’t want investors to look at your derivatives and start worrying, is this company doing the right thing?”
Finance teams generally have two ways to account for their programs in their financials, what Dhargalkar called an easy way and a hard way for the accounting team.
The easy way is to show the volatility as it’s happening, whether that involves exchange rates or commodity prices, and not show the impact of the hedge until it happens, even if that’s a year or so down the road.
“In the general accounting treatment, you mark these derivatives, these transactions, to market, but you don’t mark your exposures to market,” he said. “You don’t pull that forward in your financials today but your hedge does get pulled forward.”
This can make financials look negative if investors don’t understand what’s going on, and for that reason it can require a lot of explaining on calls.
“You explain to investors, ‘Trust us. We know what we’re doing. We’re hedging against this price that we’re worried about increasing a year from now,’” he said.
The other approach removes the negative-looking volatility from the financials by enabling the finance team to show, or “leak,” that volatility only when the hedging impact…
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