When I talk about building a diversified hedging portfolio as a business, I often use the analogy of building an investment portfolio as an individual.
With an individual investment portfolio, a mix of different, non-correlated asset classes (i.e., stocks, bonds, etc.) is used by wealth management advisers to minimize risk and maximize long-term results—no matter if it’s a bull or bear market.
Similarly, with a diversified hedging portfolio, a mix of non-correlated tools is used to minimize volatility and maximize business results—regardless of how the market behaves.
The idea? Companies with commodity exposure that grow and thrive over time are NOT the ones that attempt to time market decisions and guess short-term directional biases, but instead those that have a disciplined and proactive risk management approach, and ultimately make money in every market environment.
How do they do it? The graphic below provides a start to the explanation.
From a buyer perspective:
An effective diversified hedging portfolio uses a mix of different tools:
- No hedge
- Tailored strategies (i.e., over-the-counter strategies, which we’ll get to in a moment)
Why this particular combination of tools?
- The non-correlated behavior of these tools mitigates and spreads risk evenly across the board.
- The combination reduces cost and volatility and increases odds for financial success—all factors almost every business looks for in its business performance.
- The potential outcome of each tool is different, which complements each others weaknesses.
Most of these tools are commonly known to financial markets with the exception of tailored (OTC) solutions. These tools can bring opportunities if used in an appropriate portion of the hedging book and with a lower or neutral relative leverage to a Future.
Let’s compare tailored solutions against the other tools in the mix:
Just like the other tools, tailored solutions have their advantages and disadvantages:
- Tailored tenor, size.
- Ability to achieve price targets not available in current markets.
- Ability to allow for opportunistic pricing.
- May include leverage.
- May not cover all the quantity ordered.
- Proactive stress testing and management may be needed.
In recent financial history, there have been plenty of cases where hedging portfolios got into trouble with unpredictable outcomes. Industry professionals have experienced volatile cycles and seen the consequences of market participants severely affected by positions taken in the name of hedging.
Most of these cases have included one of the following common factors:
- Leveraged positions: In other words, the impacted company sold multiple options to the original order size to finance positions taken on day one, or the overall hedged exposure ended up being too large relative to what the company was supposed to cover.
- Concentration of tools: Companies used a disproportional concentration of positions in one or too few tools, making the portfolio exposed.
So, if we’re focusing on using these tailored (OTC) solutions to mitigate risk and maximize performance, one specific possibility comes to mind: A Delta 1 or < 1 approach.
What does a Delta 1 or < 1 tailored solution mean?
- Removing or minimizing the leverage from a tailored (OTC) solution to match a company’s hedging policy tolerance, while still taking advantage of its positive contribution.
- That the potential outcome may not be greater than an equal quantity of a futures/forwards position.
A mining company is looking to sell September 2018 copper with the following objectives:
- Sell above $7,000 dollars-ton relative to today’s market of $6,934 (September 2018 LME copper forward closing price as of April 17, 2018).
- Have a price at $6,800 in case markets fall.
- No leverage (short options) involved on the strategy.
- No premium cost for the strategy.
Here’s what the designed tailored (OTC) solution would look like:
Short Accumulating Swap – How does it work?
Every day, during the strategy period, the LME closing price for the September 2018 forward (i.e., official exchange price) does not close at or below $6,750 and the mining company sells one fraction of the order at $7,100.
If the exchange closing price in any day is at or below $6,750, accumulation at $7,100 stops and the mining company retains all sold positions accumulated until that day.
For the non-sold positions (in the event of the above scenario), a price of $6,800 activates (in a $6,750 or lower market) to fix the price of the remaining not-sold quantity until that day.
And, the strategy is designed with no premium cost for the mining company and with no leverage (no short options).
At the end of the day, using a Delta One strategy within your hedging performance can help you better mitigate risk. It can also help you maximize performance—no matter the market conditions.