So why would a company enter into a hedge that becomes a cash burden? Remember entering into a hedge position is a way to lock in potential future exposure to a commodities volatility, however just because you think prices are going up in the future does not necessarily mean that they will. Should prices slide and not rise, for example the mentioned Utility “buy position” becomes a loss margin call cash exposure. The position now has a loss associated with it.
So why would a company do this? Well as much as there is a downside to the hedge, there is much to gain as prices go up. By locking in futures prices in a rising market companies will find themselves “in the money” and often very profitable or more competitive as a result of the profitable hedge. The airline industry is a good example of an industry that can benefit from locking in fuel prices in a rising market. Should the airline buy early in a rising fuels market they can be more competitive and pass along some of the savings to their customers or realize the gain on the balance sheet, but it is not always a win scenario. However, the incentive is there to take a position. So how can companies better manage this important financial process and potential cash exposure?
As mentioned, the first step is to have a company risk policy and procedure that spells out the amount of risk and reward or stop loss levels that a company is willing to endure. Once that is in place, a company will want to get a good ETRM-CTRM system that will help capture, manage and measure the risk associated with the position. ETRM-CTRM software solutions are designed to capture the physical long and short positions along with the offsetting hedge positions true financial exposure position against daily market moves. Tracking this is important because it has the potential to affect the cash flow or liquidity of the company and knowing the mark-to-market or position/margin exposure (long or short) of the hedge against the underlying physical position is a must.
Complicating matters are standards and best practices associated with the accounting of hedging activity called derivative hedge accounting. Derivative hedge accounting is the process of accounting and reporting hedging activities in accordance with the standards and best practices associated with the Financial Accounting Standards Board –FASB or for short FAS. In particular, there are some FAS standards that are directly associated with derivative hedge accounting, mainly FAS 133 and FAS 157. These are very complex back-office processes that require specialized systems to manage this important financial accounting standards compliance need. Comprehensive ETRM-CTRM systems back-office functionality usually will offer support for FAS 133 & FAS 157 compliance automation.
About Pioneer Solutions LLC:
Pioneer Solutions is a global provider of commodity management software, CTRM-ETRM products and emissions compliance -EMIS solutions serving some of the largest utilities in the US and Europe.
Voted “Preferred ETRM-CTRM System” by our clients and peers, Pioneer Solutions’ “TRMTracker” is a FARRMS advanced architecture based solution that is changing the marketplace with its all web-based comprehensive energy and all commodity trading & risk management (ETRM-CTRM) software features. Built from the back-office forward by industry professionals, TRMTracker features the most comprehensive back-office available in the ETRM space with its advanced (FARRMS) formula-driven settlement and billing engine including the top-rated derivative hedge accounting automation module available.
FARRMS’ flexible and malleable, template and formula-driven architecture requires no coding to configure and maintain thus lowering the total cost of ownership while increasing the longevity of the platform’s ability to meet current and future demands. This organically built; work-flow driven architecture supports the straight-through processing of deals, from deal capture to risk management, scheduling, settlement and accounting processing (GL entries). TRMTracker’s risk engine offers robust, all web-based OLAP (slice & dice, drillable) reporting of all ETRM-CTRM at risk models including enterprise risk metrics like CFaR, TPE, PFE, EaR, Credit Risk Management -CVaR and more!