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Board of Directors &
Hedging Programmes
Boards of directors need to take more responsibility for hedging processes, and most
need greater technical assistance.
By Carlos Blanco & J.R. Aragonés
A
s commodity prices rocketed to record highs last year However, many boards lack even a single member with any
many end-user firms faced what they believed were ‘do hands on experience in trading or risk management who could
or die’ imperatives to lock-in purchase costs. The provide leadership in formulating an effective hedging policy.
management at many of those firms now face prodigious This shortcoming puts many firms at unnecessary risk of
mark-to-market losses after those record prices were followed by making poor decisions and not meeting shareholder
record price drops. Paradoxically, some firms have cancelled or expectations and investment requirements.
reduced their hedging programmes and have expressed a In order to fulfil its fiduciary duties, the board is responsible
reluctance to manage future market for bringing in whatever outside
price risk, even though prices are a
... many boards lack even a
expertise is necessary to properly
fraction of what they were in 2008.
single member with any
evaluate and interpret sometimes
Unfortunately, firms with a well complex and arcane subject matters
thought out and executed hedging
hands on experience in
such as hedging with derivatives.
strategy seem to be the exception rather trading or risk management Corporate governance and risk
than the rule. As a result, many of these management have often been
decisions are made in crisis mode, often ‘helped’ by ‘hedging approached as separate disciplines. Few board members are
experts’ providing dubious advice based on their views ‘risk literate’ and very few risk managers have the breadth of
regarding the expected direction of commodity markets. skills required to communicate with board members to
understand or influence the firm’s strategy risk appetite. For
Hedging as an Investment Policy Decision example, some members of boards should understand the
How a firm manages significant market risks is implications of hedge effectiveness rules in earnings variability
fundamentally an investment policy decision that should be in the context of the markets where the firm operates as well as
addressed at board level. The board is responsible for setting the counterparty risk arising from hedging price risk (Figure 1).
the business objectives for the firm, as well as establishing the Boards also need to be actively involved to ensure that the
risk tolerance and ‘boundaries’ for management to accomplish risk management group’s roles and responsibilities are aligned
those objectives. However, the board should avoid micro- with shareholder value creation (or at least the prevention of
managing the hedge process. Their responsibility is to set value destruction). Unless the risk management efforts are
overall policy, not to evaluate individual transactions or made in the context of the generation of sustainable profits for
trading instruments. shareholders, these activities may ultimately end up destroying
value and negatively interfering with the
Figure 1: Counterparty Exposure Profile for a Fixed-for-Floating
business strategy of a firm.
Power Swap With Quarterly Settlements The hedging policy statement should
have a clear link to desired action. Many
boards lack the courage to make such a
statement, falling back on vague terms
such as ‘prudent’, ‘reasonable’ or
‘strategic’ that are largely immune from
criticism. In addition, boards should set
the agenda for the risk group at the
organisation. Risk groups that realign
their focus on shareholder value creation
and ensure that the material sources of
uncertainty are identified, understood
and explicitly brought into the decision
making process will succeed in moving
beyond a purely reactive role to assisting
in the overall strategic decision making
Source: NquantX, LLC
process at their firms.
44 worldPower 2009
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