middlemarket

Hedging with Derivatives; Part 3 of 3: Commodity or Product Input Risk

Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs.  For example, energy intensive manufacturers and transportation companies can be sensitive to the price of gas.  Food product companies can be sensitive to fluctuations in the price of certain agricultural commodities.  Futures contracts on commodities can mitigate a portion of this type of risk.

Futures contracts are sometimes confused with forward contracts.  While similar, they are not at all the same.  A forward contract is an agreement between two parties (such as a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future date at an agreed-upon price.  It is a privately negotiated contract that is not conducted in an organized         marketplace or exchange.

Futures contracts, while similar to forward contracts, have certain features that make them more useful for risk management.  Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location and accepted qualities and grades. The contract specifications differ depending on the commodity in question, but this is the general idea:

A flour miller is concerned about the risk of wheat price increases for wheat to be purchased in November. Wheat futures for December delivery are currently trading at $4.20/Bu, and the typical basis at the miller’s location is $0.15 over futures. The miller hedges this risk by taking a long position (buying) the December wheat future at $4.20. In November, the futures price has increased to $4.40, and wheat is selling locally for $4.55. The miller lifts the hedge by selling back the futures position at $4.40, resulting in a profit of $0.20/Bu. This profit is then applied to the cash purchase cost of $4.55/Bu, resulting in a net cost of $4.35, which is the price expected when the hedge was placed.

For companies sensitive to raw material prices, raw material price variances should be isolated and included in your KPI reporting.  Implementing an effective commodity hedge strategy can minimize these price variances, and the effectiveness of your hedge strategy should be measured and included in the reporting

This concludes the 3 part series explaining how middle market companies can hedge their risks with derivatives.  Happy hedging!

.

Hedging with Derivatives; Part 2 of 3: Interest Rate Risk

If variable interest rates leave your company exposed, you should consider an interest rate hedging strategy.  The most common method is a ‘vanilla’ interest rate swap which can be used to effectively convert all or part of a variable (LIBOR + X) rate loan into a fixed rate loan, thereby mitigating the risk of fluctuating exchange rates.  Simple example:  You have a $2 million loan that pays a variable interest rate.  You can enter into a swap agreement whereby you will borrow $1 million at a fixed rate and invest it in a security that earns a variable rate.  This will reduce your exposure to fluctuations in the variable LIBOR rate.

Another situation that may necessitate an interest rate hedging strategy is when you are anticipating a significant inflow or outflow of cash to take place in the future, perhaps one year from now.  The viability of the strategy may depend to some degree on the interest rate at that time, and you do not know what that interest rate will be.  By purchasing a Treasury futures contract, you could effectively ‘lock-in’ the interest rate now.  This will take one important variable out of the equation and make it easier to focus on the other aspects of the deal.

As with other types of hedging, remember the purpose of a hedge program is to mitigate risk.

Next up:  Hedging with Derivatives; Part 3 of 3:  Commodity or Product Input Risk

HR1105 to deregulate #middlemarket #PE

H.R. 1105, the Small Business Capital Access and Job Preservation Act of 2013, would allow middle market investors access to capital and exempt investment advisers from having to register with the Securities and Exchange Commission (SEC). Currently under the Dodd-Frank Act, private equity fund managers are subject to time-intensive and capital-constraining registration requirements.

The Association for Corporate Growth (ACG) is in support of this bill.  Their press release is attached here.