Hedging 101 – Part Five: Risk Policies
In our previous Hedging 101 posts we defined many foundational terms and provided examples of how hedging can be used to protect a company’s margin. Before introducing additional hedging tools and integrating market data, we want to take a little detour. We want to discuss an important item that every firm needs – a risk policy.
What Is A Risk Policy?
A risk policy can be as simple as a few guidelines or a full-fledged document. The simple definition of a risk policy is a set of rules or limits which outline what type(s) of risk your company is willing to accept, or not accept.
One Example Of A Risk Policy In Action
Within the propane industry, firms provide their customers with different types of pricing plans. Examples of different plans could be as follows:
- fixed price
- budget
- keep full
These plans all have different margin objectives and are typically offered to customers at one particular time of year.
Example
Here is an example using our hypothetical TFD (Twin Feathers Distributors) company. On July 1st, TFD will send all their customers a proposal to purchase fixed price propane for the next 10 months at a price of $2.00/gallon. Through this pricing plan TFD desires to make a $1.00/gallon margin. The company has the ability to sell 1 million gallons at that price.
Identifying Risks – Being Short Financially
Before describing TFD’s risk policy, we need to identify some important risks that TFD faces. They have the possibility of being short (see Part Three) financially by selling this fixed price product to their customers.
Possible Policies To Cover This Risk
TFD could be short because they may receive notification from customers agreeing to their price and TFD may not have hedged their margin. To address this possibility, TFD might create one (or more) risk policies like what are shown below.
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- Before offering any price program, TFD needs to purchase 100% financial protection of estimated sales volume that ensures their margin objective.
- Prior to offering any price program, TFD needs to purchase 50% financial protection of estimated sales volume that ensures their margin objective. Then they are required to purchase the remaining financial protection in 25% increments based on sales commitments.
- As customers respond to the price offering, TFD needs to purchase financial protection on a weekly basis until all finalized sales are protected.
Other Possible Risks – Being Long Financially
From the above possibilities we can see that multiple risk policies could be implemented. We can also see that we are addressing only one potential risk – TFD being short. There is also a need to address TFD being long (see Part Three) financially. This situation occurs in both items 1 and 2 above because TFD chose a policy where they purchase protection before selling to customers.
Is There A Risk Policy That Is Right For Everyone?
Unfortunately, no. There is no one risk policy that is right for everyone. Risk policies are important because they help create guidelines, but not everyone needs the same set of rules. The reason for that is that every person, and entity, has a different tolerance for risk.
Risk Policy Discussions Are Important!
Risk Policy discussions may not be glamorous or exciting; however, they are necessary. A risk policy (or policies) helps to ensure your business is not taking on unnecessary or unwanted risks. And protecting your business against risk is what hedging is all about.
Watch our blog for more entries in the Hedging 101 series. The next post will jump back into alternative financial hedging strategies.
Hedging 101 – Part Five: Risk Policies
By JD Buss
