Treasury & Risk:  Welcome, Amol. Since this is a study you repeat periodically, can you shed light on how the proportion of companies hedging these risks is changing?

Amol Dhargalkar:  Sure. The proportion of companies hedging their interest rate risk increased 16 percent [6 percentage points] over three years. In our 2015 survey, 37 percent of those companies that had interest rate risk were using derivatives to hedge it, and by 2018, that number increased to 43 percent. The proportion hedging currency risks also increased, from 55 percent in 2015 to 59 percent in 2018.

However, the proportion hedging their commodity risk fell pretty significantly—from 49 percent in 2015 to just 37 percent in 2018.

T&R:  Why do you think fewer companies are hedging commodity exposures?

AD:  I have a few explanations, some based on the study and some just from the knowledge that we have gained as a firm by working with more than 3,000 companies across the globe in these areas.

One reason is that supplier contracts and payments naturally fall under procurement rather than the financial part of the organization, the domain of treasury or the CFO. There might sometimes be a gap in alignment between those managing the company's financial risks and those who are aware of where commodity risks reside.

Another reason is that commodity hedging is quite nuanced, and figuring out how to navigate commodity markets can be challenging. You can't just hedge fuel. You have to choose whether your exposure is Brent [crude] or WTI [West Texas Intermediate]. If you're an airline, neither of those is what you need. You need to hedge the price of jet fuel—but jet fuel is liquid only so far out from a tenor standpoint. To hedge farther than that, you have to use a proxy. And all of a sudden, that becomes really complicated. Not only does that complexity mean that it will take more time to determine appropriate hedges, but the treasurer might also wonder how to explain the hedges to internal and external stakeholders.

And then a third factor for why fewer companies use derivatives to hedge commodity risks—and why the proportion has declined from three years ago—is that in many cases commodity prices have fallen significantly. Our experience suggests that when commodity prices are low, companies don't feel as compelled to hedge because they're not feeling the pain of higher-than-expected costs.

T&R:  The majority of companies are not using derivatives to hedge their risks. Are they using other risk management techniques to protect their financials?

AD:  On the commodity side, the most common approach is to use supplier agreements to mitigate those exposures by referencing an underlying commodity in the contract. Pricing of a particular widget might be tied to the price of copper, for example. That might not qualify as a derivative—although it might also, depending on how it's written. If it doesn't qualify as a derivative, it won't get called out on the financial statements because there's no specific standard for that [and so Chatham won't see it in this study], but it will in essence be a form of hedge.

On the interest-rate side, many U.S. public companies finance themselves with bonds. The 9 percent of companies in our study that we considered to have no interest-rate risk were those with no material debts. Some of the companies that are not actively managing those risks have a largely fixed-rate capital structure in place. And that can mitigate risks to a certain degree. However, we're seeing a lot of companies that are looking to issue new bonds—even if they're going to be fixed-rate—utilizing tools like forward-starting interest rate swaps, in advance of doing that issuance, to manage the risk that rates will change before the bond deal is finalized.

And then with respect to FX exposure, a lot of companies try to mitigate their currency risks naturally. In other words, the business will try to align the currencies in which they're generating revenue with the currencies in which they have costs. For example, a company that manufactures in China but then sells those goods in a number of different currencies might try to move some operations from China to the different regions where they are selling goods. This is a long process and takes much more time than entering into hedging programs.

T&R:  Another interesting finding from your research is that companies with revenues under US$1 billion annually are much less likely to be using derivatives to manage their interest rate, FX, and commodity risks. Only 33 percent of these smaller companies are hedging one or more of the exposures they face, compared with 59 percent of companies that have over $20 billion in annual revenues. Is a lack of resources and expertise the key reason smaller companies are doing less to mitigate these risks?

AD:  That's a large driver of it. The smaller the company and smaller the treasury team, the harder it is to really focus on financial risk management and develop a strategy. That often has to do with staffing, on either the treasury or accounting side, or both, and an inability to make the investment required to do this well. In addition, smaller companies are sometimes growing extremely fast, so managing financial risks is not considered as critical in the immediate term as executing on their operational priorities.

T&R:  For companies that haven't actively managed these risks in the past, how should the treasury team determine whether they need a hedging program?

AD:  First, they need to understand their risks in each of these areas. And second, they need to understand the impact that significant market movements would have on their financials. So it's important not just to know where risks are coming from, but also to quantify them and understand how they measure up relative to the company's key metrics and stated risk tolerance. We frequently work with treasurers who end up scaling back a hedging program, or not starting one at all, because once they evaluate all their exposures, they realize some of the risks are acceptable to the organization.

T&R:  Is that something they would determine through scenario planning—by calculating the effects on the business if, for example, interest rates rise to a certain level?

AD:  Yes, scenario planning, but using market-driven data to build those scenarios. It's not just 'Let me stick my finger in the air and see what happens if interest rates rise by 100 basis points.' Instead, they should use market-based elements—consider what the probability is of that occurring over a specific timeframe. Such an analysis can provide great insights for senior managers who are deciding whether it makes sense to change or augment the company's hedging program.

See also:

• Incorporating Expectations into Hedging Decisions
• FX Proxy Hedging Using Machine Learning
• Options: A Good Option for Currency Hedging
• Cash Flow Hedging Best Practices
• Much Better Balance Sheet Hedging

T&R:  If a treasury group determines that they should be more actively managing financial risks, where should they start in establishing a derivatives-hedging program?

AD:  I would suggest they start by looking at the risk that is causing the most conversation. Ideally, the treasurer or CFO would take a holistic approach. They would look across currency, interest rate, and commodity risks to determine which are the most impactful, how they impact one another, and which the company can actually do something about. But that doesn't always resonate most with senior managers.

Instead, it often makes more sense to choose one highly visible risk, then evaluate it, create a hedging framework around it, communicate internally about how you are going to mitigate that risk, and work to execute your plan according to your risk tolerance. When that program is successful, you can turn your attention to additional risks.

T&R:  So, implement your hedging program incrementally.

AD:  Yes, absolutely. Financial risk management is multidisciplinary and requires a lot of pockets of expertise, across the company or with partners you're working with. It can be very challenging to kick off a holistic risk management initiative, unless the leadership team has a strong understanding of the benefits to that approach.