Hedging Policy in Corporate Treasuries

2. How do we build it?



Author: Federico Bellanti

April 22, 2024

Good: where do we start?

In this article I intend to illustrate the criteria and principles that should inspire the drafting of a Hedging Policy that can be truly useful and is adopted consistently in the management of market risks.

As I already mentioned in my previous post, we will never find two Hedging Policies from different companies that are identical or extremely similar to each other: they may possibly share the same objectives, the distribution of roles and responsibilities, the list of financial instruments allowed, but it will always be a "tailor-made" document, suitable for incorporating the unique characteristics of the specific business reality, and supported by processes and systems that make it an integral part of the corporate governance system.


Articulate your objectives clearly


The cornerstone of an effective hedging policy is a simple and clear definition of its objectives which must be perfectly aligned with the broader ones of the operational and financial management.


The company may have the objective of removing the uncertainty, as far as possible, with consequent stabilization of cash flows, and will consequently want to adopt a series of measures suitable for locking in advance certain exchange rates, or the purchase price of certain raw materials and so on. This will give greater predictability and stability on results and operating margins.


But we could find different objectives, in different types of business contexts, in which the variability of market prices (rates, exchange rates, commodities) is instead inherent to the normal operating cycle, and not in conflict with the achievement of the corporate objectives, at least within a certain time horizon: think of Utilities, operating under a concession regime, which contractually have the right and duty to transfer increases or decreases in the cost of raw materials to the end user.


Strategic integration


It’s imperative that the hedging policy works in harmony with the company’s overall strategic plans. For example, if a company plans to expand its commercial offering into a variety of foreign countries, there is an expectation that foreign currency risk is adequately identified, assessed and managed.


Such focus will likely be very different for a company that is purely domestic, and that may instead want to concentrates its efforts on managing the risk arising from interest rates, should there be a material reliance on floating rate borrowings for funding new strategic growth initiatives.


Comprehensive Risk Landscape

Identifying and assessing financial market risks is a foundational step in developing a robust hedging policy. A company must thoroughly understand the variety of risks it faces in the course of its business operations. These market risks can broadly be categorized into foreign exchange risk, interest rate risk, commodity price risk, and market contingent credit risk.


Let's look at them quickly:


Foreign Exchange Risk

Foreign exchange risk emerges from fluctuations in currency prices which can affect the company's financial performance. This risk manifests in several forms:

  1. Transactional FX Exposure: This includes both trade-related exposures, which affect non-functional currency revenues and expenses, and settlement-related exposures, impacting receivables or payables in foreign currencies. Additionally, it involves the repayment of debts denominated in foreign currencies.
  2. Translational FX Exposure: This occurs when the financial statements of foreign subsidiaries are consolidated. It involves translating income statements and balance sheets from a subsidiary’s functional currency into the parent company’s reporting currency.
  3. Net Investment Exposure: This arises from holding equity in foreign subsidiaries, where the investment is denominated in a foreign currency.


Each of these exposures lends itself to distinct considerations for effective management and hedging.


Interest Rate Risk

Interest rate risk involves the risk of rising interest costs associated with floating rate borrowings and the fluctuation in market values of fixed-rate debt instruments. A hedge against interest rate risk helps stabilize the company's financial obligations and maintain predictable finance costs.


Commodities Price Risk

Commodity price risk is critical for companies that rely on raw materials for their production processes. Fluctuations in commodity prices, including energy, can significantly impact production costs and profit margins. Hedging against this risk involves securing price levels for future purchases to avoid unexpected cost surges.


Mark-to-Market Credit Risk

This reflects the risk of a default by a hedging provider when the net mark-to-market amount is in favor of the company. It is crucial to manage relationships with counterparties and continually assess their credit worthiness and maximum exposure in order to mitigate this risk.

How we assess and measure market risks

There are decisions to be made when defining the traits of a Hedging Policy. Such decisions will determine the way the company will address and manage the risks so their carful determination is of paramount importance:


  • Net Aggregated Basis: it is normally a good idea to measure risks on a net aggregated basis, so that the risk is assessed by considering offsetting exposures, even those originating from different segments of the business, to determine a net exposure level. This holistic view helps in understanding the actual risk exposure.
  • Natural Hedging and Operational Efficiency: while natural hedging (the offset of market risk that occurs in the ordinary course of business) is normally desirable, the business should not seek to achieve the internal offset of exposures at the expenses of operational efficiency and quality of service. For example, the selection of local currency suppliers in preference to international suppliers, cannot be solely justified by the achievement of an internal currency risk offset if this comes at detriment of the quality and cost of the service received.
  • Contractual and Estimated Exposures: the size of risk exposure is usually based on enforceable contractual agreements. However, for certain FX and commodity price risks, it may be appropriate to use conservative estimates from relevant business operations.
  • Selective Hedging: not all identified risks require hedging. The necessity for hedging is determined based on potential negative impacts on financial performance. The existence of a documented market risk does not automatically warrant a requirement for hedging initiatives: certain types of exposures, indeed, may actually be considered acceptable or even beneficial to the company. This happens for example when the company has a right, or sufficient market power, to transfer any price increase in its procurement onto the selling price of its goods/services, and symmetrically will be in a position to having to reduce selling prices when the opposite dynamic occurs


Indirect and implicit exposures


Several situations may not present direct market risks but still impact the company's financial outcomes:


  • FX Indexation: commercial contracts may specify payments in the domestic currency, but the amounts are determined by future FX rates. This creates a hidden FX risk which must be managed as explicitly as direct exposures.
  • Price Adjustment provisions: long-term supply agreements may link costs to commodity prices, transferring price risk to the company. It's crucial for departments like procurement to involve the treasury team in drafting such contracts to ensure risks are manageable and hedgeable.
  • Other Indirect Exposures: when direct hedging instruments are unavailable or illiquid, the company might need to hedge against correlated risks. The senior management should validate the inclusion of such indirect exposures based on consistent statistical correlations and reassess them periodically.


Effective risk identification and assessment require a comprehensive understanding of all direct and indirect financial exposures. By adhering to structured principles and involving key stakeholders across the organization, companies can develop a nuanced understanding of their risk profile. This thorough approach enables the crafting of a hedging policy that not only protects against adverse financial impacts but also supports strategic business objectives.

An effective corporate hedging strategy must integrate dynamic exposure monitoring — a core feature of my Market Risk management offering.

What other elements should we include

A truly comprehensive Hedging Policy will address a variety of issues in an organic manner


Operational limits and Risk Tolerance


Setting Limits:

Defining risk tolerance involves quantifying how much risk is acceptable and setting limits to ensure that exposure stays within these bounds. This could include setting a minimum and a maximum on the percentage of revenue at risk from foreign exchange fluctuations or defining thresholds for interest rate risk that the company can tolerate, also bearing in mind the financial costs associated to their neutralization.


Dynamic Adjustments:

The company should regularly review and adjust these limits in response to changing market conditions, to change in the commercial strategy and in the overall financial performance. This dynamic approach ensures that the hedging strategy remains relevant and effective.


Definition of Roles and Responsibilities


A well-defined governance structure is essential for the effective implementation and oversight of a hedging policy. This framework should clearly delineate roles and responsibilities across the organization to ensure accountability and efficient management of hedging activities.


Roles and responsibilities:

Key roles typically include the Chief Financial Officer (CFO), the Treasurer, and other members of the senior financial team, including a Risk Management Committee who are responsible for setting strategic hedging objectives and overall policy direction. Specific responsibilities should be assigned for initiating, approving, and executing hedging strategies. For example, the Treasurer might oversee the execution with assigned margins of discretion, while the CFO or the Risk Management Committee could handle high-level strategy and policy approvals.


Checks and Balances:

To ensure checks and balances, the policy should mandate the separation of duties among those who execute trades, those who account for and report on these activities, and those who oversee compliance. This separation reduces the risk of errors or unethical practices going unnoticed. Additionally, an independent risk management function should be established to monitor hedging activities and ensure they align with the company’s risk tolerance and compliance requirements.


Communication and Reporting:

Effective communication channels must be established to ensure that information regarding hedging activities is disseminated appropriately across the organization. Regular reporting to the board or a specific risk committee is crucial for maintaining transparency and for strategic decision-making.


Ensuring Compliance:

The governance structure must also ensure compliance with all relevant local and international laws and regulations. This includes regular updates to the hedging policy to reflect changes in financial regulations and market conditions.

And the products?

The selection of hedging instruments must be driven by their ability to meet the defined objectives and stay within risk limits.


The Policy will therefore contain a list, as broad as possible, of tools considered adequate for the purpose, also detailing the approval process necessary to add new products if the need arises


Non-Standard Products

In cases where “vanilla” instruments do not adequately address the risks, the Policy may allow the adoption of more complex products. However, these require a deeper analysis to ensure they do not introduce additional risks and their implications are adequately understood.

Operational Aspects

Execution of Hedging transactions:

Detailed guidelines on the execution of trades include specifying who is authorized to initiate and approve transactions and under what conditions. This ensures compliance with the policy and accountability. The issuance of clear and straightforward Mandate Letters to each member of the Trading Team is a simple measure to ensure full accountability.


Transaction Monitoring and Management:

The Hedging Policy should then dedicate a large section to all "post-trade" activities, activities that will normally be attributed to functions independent of the Treasury.

These should include:

  • monitoring the "life-cycle" of each derivative transaction;
  • monitoring Mark-to-Market;
  • monitoring the accounting treatment, whether in hedge accounting or not;
  • monitoring the use of counterparties;
  • monitoring regulatory limits ( e.g. trade clearing thresholds)
  • monitoring the current and prospective use of cash collateral payments, if any;


Treasury Documentation:

The Hedging Policy should then adequately articulate the standard contractual terms for conducting derivatives transactions, establishing for example the need to always (or preferably) operate within an ISDA Master Agreement or another equivalent document. The same Policy should establish the company's approach in negotiating the many commercial clauses of this Master Agreement in order to guarantee on the one hand the homogeneous treatment of all its counterparties, and on the other the compatibility with all those financial covenants and constraints that may come into play.


Selection of market counterparties:

Finally, a good Hedging Policy should establish the rules for the selection of counterparties in hedging transactions, ensuring on the one hand the company's protection against a deterioration in counterparty credit risk, and on the other helping to strengthen its reputation as a fair and reasonable player when distributing business to its relationship banks

A well-crafted hedging policy is a dynamic tool that aligns a company’s financial activities with its core objectives and risk management framework. By adhering to the principles outlined in this guide, companies can navigate financial risks with confidence and strategic foresight, ensuring financial stability and compliance in a complex global market.

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