Commodity Price

Risk Management
A manual of hedging commodity
price risk for corporates
 Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

Contents
1. Introduction 04

2. Commodity Price Risk – An Overview 10

3. How do Corporates Address

Commodity Price Risk? 16

4. What is Commodity Price Risk Hedging? 20

5. Methodology of Hedging Commodity Price Risk 24

6. Using Futures and Options to Hedge

Commodity Price Risk 30

7. Benefits of Hedging Commodity Price Risk 34

8. Understanding Hedge Accounting 36

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Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

1. Introduction Figure 1: A typical risk universe of a corporate as part of the enterprise risk management framework

Strategic Operations Compliance Financial

Emergence of Risk Management and instruments to manage or ‘hedge’ against •• Board Performance / •• Marketing and Advertising •• Management Fraud •• Interest Rate Changes
Corporate Treasury insurable or uninsurable risks began Tone at the Top •• Research and Development •• Contract •• Foreign Exchange
The origins of risk management pre-dates to be used – and went on to be widely
•• Shareholder Expectations •• Customer/ Support •• Ethics Fluctuations
the 1700s with the use of probability used from the 1980s. The wide-spread
theory to solve puzzles and its use was use of derivatives naturally lead to •• Third-Party Relationships Management •• Liability •• Commodity Price
largely limited for theoretical purposes the formation of various international •• Strategic Planning •• Procurement and Inventory Fluctuations
•• Trade Regulations
– however, during World War II risk regulations of using derivatives with •• Annual Budgeting & •• Transportation and •• Cash Visibility &
•• Customs Regulations
management began to be studied and financial institutions developing Forecasting Logistics Forecasting Capabilities
•• Tax Compliance and Audit
implemented for various purposes. internal risk management models and •• Cash Movement –
•• Alliances and •• Recruiting and Retention Management
Traditionally, risk management in the capital calculation measures to protect Domestic & Cross-Border
Partnerships •• IT Security/ Access
market place was always associated themselves from unanticipated risks and •• Accounting, Reporting and
•• Competition •• Funding Abilities
with the use of insurance to protect reduce regulatory capital. •• Natural Events Disclosure
•• Macro-Economic Factors •• Liquidity Concentration
institutions and individuals from bearing •• Geopolitical Events
losses associated with accidents. At the same time, in the corporate •• Socio – Political Events •• Working Capital
•• Property, Plant and
space as well, the governance of risk Management
•• Employee Equipment
However, from the 1950s, there were management became essential with Communication •• Insurance
•• Scalability
other forms of risk management that the emergence of the enterprise risk •• Debt Management
•• Growth •• Management Information
emerged as alternatives to insurance management framework – a framework
•• Innovation Systems •• Equity
– especially when insurance coverage that helps identify the various risks
became costly and did not cover the risk affecting the institution (see figure 1) •• Control Environment
exposure expected by the institutions. across its business and operations and •• Environment / Health and
Modern risk management practices measures and plans to address, mitigate Safety
began to emerge around 1955 and in and monitor its impact on the institution
•• Intellectual Property /
the 1970s, the use of derivatives as
Trademarks

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Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

At many of the enterprise risk Figure 2: An illustration of the typical roles of the treasury department of a corporate –– Budget-to-actual variance – which •• Commodity price fluctuations that The objective of the financial supply chain
management meetings, financial risk may especially have a significant may affect the price of the commodity management function of a corporate
management became an important impact on the profitability of an entity procured, maintained as inventory (raw treasury is to “ensure adequate
discussion point at the Board of Directors that is either significantly dependent material or finished goods) or sold to liquidity” to the underlying business
and senior management level due Interest rate risk on purchasing from overseas overseas parties or even on domestic functions either through cash or through
to the emergence of additional risks management suppliers or selling goods to transactions – where the reference the utilization of short term or long term
upon expanding business into new overseas buyers price of the commodity is affected by debt facilities - and the optimization of
geographies, establishing trade relations price fluctuations. the cost of financing by deploying surplus
with overseas buyers and suppliers –– Foreign currency translation with funds in those investment instruments
and managing liquidity and cost of respect to consolidation of financial that are permitted as per the risk appetite
debt through effective funding and performance – limited to entities of the entity.
investment strategies. Accordingly since Foreign Commodity having subsidiaries outside of its
Financial risk
the late 1980s, several corporates began exchange risk price risk country of domicile
management
to establish a dedicated unit separate management management
from the traditional financial & accounts
Figure 3: Key Components of the Financial Risk Management Lifecycle
department - which would manage these
financial risks and supply chain costs for
the institution – this would be known as Risk Appetite
the treasury department for a corporate.
Risk Management Strategy
An Overview of Corporate Treasury
Risk Management
Treasury management activities may
Treasury Risk
be distinctly divided between the Exposure Exposure Hedging
Management mitigation/
financial risk management and identification/ aggregation/ transaction
performance
financial supply chain management recognition consolidation execution
assessment
functions respectively as highlighted in
figure 2 below.

The objective of the financial risk Risk Management Governance

management function of a corporate
treasury is to “protect and preserve” Risk Operating Model
the value generated from the underlying
business against external market forces
Financial
such as: Cash & liquidity Investment
supply chain
•• Changes in the interest rates in the management management management
domestic or overseas geographies
which may have an adverse impact on
the interest charges on the existing
domestic or foreign currency loan
facilities undertaken by the group or
its entities Debt
management
•• Foreign currency movements that may
impact an entity in the following ways:
–– Gain/ loss on foreign exchange
transaction within its trade
cycle – mainly due to the fluctuation in
currency movements resulting from
the timing difference on recognizing
the payable/ receivable for import/
export to actually paying/ receiving
the foreign exchange amount

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Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

Components of the Financial Risk controls established for monitoring and used here include ‘gross exposure’
Management Lifecycle flagging instances of potential breaches which is the total value of exposures to
The most important element with to the risk management strategy and a particular financial risk and position
respect to risk management to establish most importantly, the information in the value chain. For example: total
and assess the “Risk Appetite” of required to measure, monitor and report value of foreign currency imports
the entity. As per the Institute of Risk the effectiveness of the risk management of bauxite in case of an aluminium
Management, risk appetite can be strategy to the Board of Directors and manufacturer. Another term used here
defined as the ‘the amount and type senior management of the entity. is ‘net exposure’ which amounts to the
of risk that an organisation is willing total value of exposures to a particular
to take in order to meet their strategic Keeping the above pillars in mind, financial risk after considering the
objectives’. It establishes the tolerance a typical financial risk management offsetting impact of the same set
that the Board of Directors is willing to lifecycle involves the following of exposures. For example: the net
accept with respect to the impact of risk work-steps: exposure to USD for an entity that
on the entity’s top-line (i.e. revenue) and imports copper ore and exports copper
•• Exposure identification and
bottom-line (i.e. EBITDA). Typically, the wires will be the total value of imports
recognition – To assess which elements
risk appetite of an entity is established in USD adjusted against the total value
of the business value chain of the
as part of the enterprise risk of exports in USD at a certain maturity
entity is affected by the specific area of
management framework – based on period of settling the payment/ receipt
financial risk i.e. interest rate changes,
which the financial risk management of USD.
commodity price or foreign currency
strategy can be established.Upon
fluctuations. This helps establish the •• Hedging transaction execution –
establishing the risk appetite, the “Risk
transactional information within the Once the total value of exposure to a
Management Strategy” is the plan or
value chain that is exposed to the financial risk has been ascertained, the
strategic goals established for achieving
specific financial risk. For example, in corporate treasury identifies a financial
the objectives within the boundaries of
case of a manufacturing company that’s instrument that can be used to ‘hedge’
the risk appetite of the entity established
primarily an importer of raw materials, or offset the impact of the exposure
by the Board of Directors. In case of
financial risk exposure would include to the financial risk. The execution
financial risk management, the risk
the following: cycle typically involves entering into
management strategy encompasses
–– Foreign currency fluctuations a derivative contract with a financial
the strategic plan to address the afore-
between the currency of purchase counterparty (either an exchange or a
mentioned financial risks affecting the
(i.e. foreign currency) and currency bank) and settling the contract upon
entity based on the level of impact it has
of settlement (i.e. INR conversion) maturity of the contract.
on the Company’s financial performance.
with respect to the time of obtaining
•• Risk mitigation/ performance
the invoice for settlement up to
With the risk appetite and risk assessment – This is the most
the time of actually making the
management strategy established for important element of the financial
import payment
financial risk management, the life- risk management lifecycle as this
–– Commodity price fluctuation with
cycle cannot be established without assessment demonstrates the degree
respect to the commodity price
having an effective “Risk Management of success of the implementation of
at the time of structuring the
Governance” by way of oversight by the the financial risk management strategy
purchase order till the time of
necessary senior management and Board based on the manner and level of
receiving the L/C or invoice (as per
of Directors of the entity coupled with meeting the desired financial risk
the purchasing terms)
policies, guidelines and mandates which management objective.
–– Interest rate fluctuations with respect
have been established for executing the
to the foreign currency financing
risk management strategy within the The next sections of this manual focus on
undertaken for the import purchase
appetite established by the entity’s Board applying the financial risk management
like the LIBOR rate at the time of
of Directors. elements to address commodity price
receiving the borrowing to the
risk – which has become a significant
interest rate at the time of repayment
The execution of the risk management focus area within the field of financial risk
(assuming that the rate of interest is
strategy depends on the manner in management and the manner in which
floating and not fixed)
which the “Risk Operating Model” has the derivative instruments provided by
been established within the entity i.e. •• Exposure aggregation and commodity derivative exchanges can help
processes for executing the strategy consolidation – The combined address a corporate’s commodity price
(manual or automated), responsibilities transaction value that is exposed to risk issues.
and activities thrusted on the personnel, the specific financial risk. Key terms

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Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

2. Commodity Price Origins of Commodity Price Risk1

The roots of commodity risk management
The evolution of exchange trading
derivative contracts for bulk commodities

Risk – An Overview
go back to the ancient times. Commercial revolved around two important
transactions in the early markets often elements: enhanced securitization of
involved a sale agreement between two the transactions and the emergence
parties that were sometimes structured of speculative trading. Both these
as a forward contract with various developments are usually connected
features/ options on the agreement. with the increasing concentration of
The contract could vary from loosely commercial activity, initially at the large
What is a Commodity? What is Commodity Price Risk?
structured between two parties to a medieval market fairs and, later, on the
If we look at the legal definition of a Commodity price risk is the financial risk
formal and notarized agreement based bourses and exchanges. Securitization
commodity, it is defined as ‘a tangible on an entity’s financial performance/
on established rules and even law. of bulk commodity transactions was
item that may be bought or sold; profitability upon fluctuations in the
Unstated terms and conditions of such facilitated by applying trading methods
something produced for commerce’. prices of commodities that are out of
agreements were often governed by that had been in use for centuries in the
Therefore, commodities are considered the control of the entity since they are
merchant convention. An agreement market for bills of exchange.
to be marketable goods or wares, such as primarily driven by external market
for a future sale would typically have a
raw or partially processed materials, farm forces. Sharp fluctuations in commodity
provision that would permit the purchaser One of the first examples of exchange
products, or even jewellery. Intangibles, prices are creating significant business
to refuse delivery if the delivered goods trading in commodities in a crude form
such as human labour, services, or challenges that can affect production
were found to be of inadequate quality emerged in Antwerp during the second
marketing & advertising, are typically not costs, product pricing, earnings and
when compared to the original sample. half of the 16th century. The development
considered to be commodities. credit availability. This price volatility
As reflected in notarial protests stretching of the Antwerp commodity market
makes it imperative for an entity to
back to ancient times, disagreement over provided sufficient liquidity to support
manage the impact of commodity
what constituted satisfactory delivery was the development of trading in “to arrive”
price fluctuations across its value chain
a common occurrence. contracts associated with the rapid
to effectively manage its financial
expansion of seaborne trade during
performance and profitability.
the period.

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Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

In the 1840s, Chicago in the United States Price Discovery in Commodity Markets Figure 4: An illustration of price discovery in crude oil
of America had become a commercial Price discovery is a process of
Crude oil future price movements (Rs/barrel)
centre with railroad and telegraph lines determining the price of a specific
connecting it with the eastern part commodity through basic supply and 4100.00
of the USA. Around this same time, demand factors prevalent in the market 3900.00
the McCormick reaper was invented place. The process of price discovery 3700.00
which eventually lead to higher wheat depends on several interrelated
3500.00
production. Midwest American farmers factors such as market structure
3300.00
came to Chicago to sell their wheat to (such as number, size, location, and
dealers who, in turn, shipped it all over competitiveness of buyers and sellers), 3100.00
the country. Unfortunately, at the time, market information (including amount, 2900.00
the city had few storage facilities and timeliness, and reliability of information), 2700.00
no established procedures either for market behaviour (procurement/ sales
2500.00
weighing the grain or for grading it. In and pricing methods), global linkages
23-Jan-17 23-Feb-17 23-Mar-17 23-Apr-17 23-May-17 23-Jun-17
short, the farmer was often at the mercy and prevalence of futures markets or
of the dealer. alternate risk management instruments. SpotPrice MCX future price NYMEX future price(Rs)

Then in 1848, a central place was Physical markets in India are generally
The price discovery approach at also a “light” and sweet crude oil with
established in Chicago where farmers considered to be fragmented and
Indian commodity exchanges have API gravity of 38.3 degrees and about
and dealers could meet to deal in "spot" impacted by information asymmetries
demonstrated their ability to align with 0.37 percent of sulphur. These qualities
grain - that is, to exchange cash for and instances of intentional external
the physical market prices as well as determine the weight of the liquid and
immediate delivery of wheat. This central influences leading to greater price
with international commodity prices, the costs associated.
place was known as the ‘Chicago Board discovery inefficiencies. However,
especially where India is a ‘price taker’
of Trade’ or ‘CBOT’. The futures contract, prices discovered in the commodities
(see figure 4). Through price discovery Benchmark/ Reference Prices in
as we know it today, evolved at the CBOT exchange market are more efficient due
at national and international levels, Commodity Markets
as farmers (sellers) and dealers (buyers) to transparency where information flows
substantial benefits have been obtained In the commodities markets, a
began to commit to future exchanges of and assimilation are instantaneous and
where market participants are able to benchmark is defined as an external
grain for cash. For instance, the farmer more importantly, reliable.
benchmark prices effectively with the reference price (i.e. outside of the
would agree with the dealer on a price
available commodity price and evaluate control of the contracting parties) that
to deliver to him 5,000 bushels of wheat Trading by participants from across
their purpose in the business value chain. are acceptable to both the buyer and
at the end of June. The bargain suited the commodity ecosystem on a
seller to be used directly or as a base for
both parties. The farmer knew how much commodity exchange encourages
The price of a commodity is also establishing the agreed price in
he would be paid for his wheat, and transparency by leading the market
characterized by various other factors the contract.
the dealer knew his costs in advance. price of the commodity close to its
such as quality, region, delivery routes,
The two parties may have exchanged a ‘fair value’. This enables companies
geographical disparities, transportation Crucially, for a benchmark to be
written contract to this effect and even and consumers to develop effective
pricing structure etc. For example, in recognised and adopted, it needs to
a small amount of money representing a hedging strategies. Such price signals are
its natural state, crude oil ranges in reflect actual prices being agreed/ traded
"guarantee” which was facilitated by essential for firms to take decisions on
density, consistency and colour. This is across the marketplace. Fluctuations in
the CBOT. production, marketing, and processing
due to the fact that oil from different commodity prices most often has a direct
of commodities, for example: farmers
geographical locations will naturally have impact on the structured margins i.e.
In 1864, the CBOT listed the first ever on expected returns among competing
its own unique properties. Approximately profitability of an entity. Where pricing
standardized "exchange traded" forward crops, small and medium enterprises
160 types of crude oil are traded in the benchmarks are transparent and similar
contracts, which were called futures and large corporates about the possible
physical market and exchanges together benchmarks are available in derivative
contracts. In 1919, the Chicago Butter future trends in relation to their
- which vary in characteristics and quality. markets, commodity price risk may be
and Egg Board - a spin-off of the CBOT, exposures, as well as consuming groups
West Texas Intermediate (‘WTI’) and managed through hedging the exposures.
was reorganized to enable member such as importers/ exporters/ traders/
Brent are two crude oil markers which Additionally, domestic paper markets
traders to allow future trading, and its consumers as to what will be the likely
are either traded as per their quoted may base the benchmark prices based
name was changed to Chicago Mercantile prices in the near future.
prices or whose prices form the basis on internationally available benchmarks,
Exchange (CME). This gave rise to the
of price or ‘proxy’ for other crude oils. with due care on the use of conversion to
global commodity futures and derivative
WTI is a light crude with an API gravity INR and the metrics considered
markets as we know today.
of 39.6 degrees and contains about 0.24 in the domestic markets. The table
percent of sulphur, marking it as “sweet” below provides a sample of benchmark
crude. In contrast, Brent is a combination physical/ paper prices typically used by
of crude oils from 15 different oil fields commodity players and exchanges.
in the Brent and North Sea areas. It is

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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

An example:
SNo Commodity Group Traded global benchmarks Features of traded domestic benchmarks

1 Crude oil Brent, Platt’s Dubai, WTI Indian crude oil futures benchmarked to CME WTI Crude Oil prices Domestic gold jewellery manufacturer
1. Value chain
2 Natural gas Henry Hub, JCC Indian Natural gas futures benchmarked to CME Henry Hub prices

3 Copper LME, COMEX Indian copper futures benchmarked to CME Copper prices. Pricing of gold
Domestic pricing based on import parity pricing linked to LME. for sale to
Purchase of gold
Processing of customers across
4 Aluminum LME Indian aluminum futures benchmarked to LME Aluminium prices. from Local bullion Full payment made
gold bars and the showroom Collections from
Domestic pricing based on import parity pricing linked to LME. dealer by fixing to the supplier at
manufacturing network based on customers across
price derived from the time of taking
5 Zinc LME Indian zinc futures benchmarked to LME Zinc prices. of ornaments/ local market linked the showrooms
international gold delivery of gold bars
Domestic pricing based on import parity pricing linked to LME. jewellery price derived from
benchmark
international gold
6 Lead LME Indian lead futures benchmarked to LME Lead prices. benchmark
Domestic pricing based on import parity pricing linked to LME.

7 Nickel LME Indian nickel futures benchmarked to LME prices.

Domestic pricing based on import parity pricing linked to LME.
2. Financial impact on commodity price movement
8 Crude Palm oil BMD Indian CPO futures are highly correlated with international
benchmarks like BMD SNo Price Impact
9 Cotton ICE - US Indian cotton (29 mm) futures have a high correlation with Indian Movement
Inventory Impact Sales Purchasing Earnings
physical market prices
1 Fall in Higher cost of inventory Reduced sales values due Increase in purchasing Net realizable value is
10 Gold CME Group (COMEX), LBMA Indian gold futures bear strong correlation with COMEX prices, as also commodity which would lead to a to lower price – which power leading to higher below cost and sales
Indian physical market prices price constraint in cash flow. impacts profitability volumes purchased realizes at lower value
11 Silver CME Group (COMEX) Indian silver futures bear strong correlation with COMEX prices, as also thereby reducing
Indian physical market prices earnings

2 Rise in Lower cost of inventory Increased sales values Decrease in purchasing Net realizable value is
commodity which would lead to due to higher price power above cost and sales
Impact of Commodity Price •• Affect inventory management solutions
price increase in cash flow realizes at same or higher
Movements on Revenue and as there is a direct impact on earnings
value thereby increasing
Profitability in case of fall in the value of inventory.
earnings
Volatility in commodity prices can impact Inventory is valued at cost or net
different players differently depending realizable value whichever is lower.
on where they lie on the value chain. Accordingly, where net realizable value
Profitability of these players is also falls below cost, there is a real impact
determined basis the variant of the to cash flows i.e., sales will realize a
commodity that the entity is dependent on lower value
within the value chain.
A rise in commodity prices can:
A fall in commodity prices can:
•• Increase sales revenue for producers
•• Decrease sales revenue for producers, if demand is not impacted by the price
potentially decreasing the value of the increase. This in turn can lead to an
organisation, and/or lead to change in increase in the value of the business.
business strategy
•• Increase competition as producers
•• Reduce or eliminate the viability of increase supply to benefit from price
production — mining and primary increases and/or new entrants seek to
producers may alter production levels take advantage of higher prices
in response to lower prices
•• Reduce profitability for businesses
•• Decrease input costs for businesses consuming such commodities (if the
consuming such commodities, thus business is unable to pass on the cost
potentially increasing profitability, increases in full), potentially reducing
which in turn can lead to an increase in the value of the organisation
value of the business

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3. How do Corporates rising commodity prices by ‘passing it

on to the customer on the finished
goods’. Alternatively, such corporates
derivatives markets as well as in the
commodity exchanges. The OTC markets
provide such corporates with the ability

Address Commodity
also tend to negotiate with their suppliers to customize the contract that best fits
towards a fixed price agreement – which with the exposure profile of the Company
becomes a difficult ordeal where the - which is not available in the exchange
price discovery and benchmark prices market due to fiduciary requirement

Price Risk?
of that commodity are transparent and of the standardisation of contracts.
easily available to all market participants. Another proponent for participating in
Similarly, corporates exposed on the the OTC market usually stems where
sales side of the value chain structure the benchmark prices available in the
pricing barriers or through stepped-price exchanges are not aligned to the price
bands within the sales contract which act discovery procedure for procuring or
Commodity price risk intrinsically is Within the commodity value chain, as an embedded derivative. Alternatively, selling the commodity by the corporate.
the uncertainty faced by corporates corporates are faced with different types most corporates look towards hedging
to source or sell a product at a price. of commodity risks including ‘inventory their sales should the commodity Example – A jewellery manufacturer
The nature & type of commodity price price risk’ with the risk of falling prices, benchmark price be available to hedge
risk varies from industry to industry. ‘basis risk’ which is the difference through a derivative instrument. A domestic bullion/ jewellery
Every company procuring a certain in benchmark price of the physical manufacturer is involved in the industrial
commodity will face the challenge of commodity and the derivative instrument Corporates on the global scale have process of refining & converting bullion
effective price management. Depending used to hedge the commodity price, and evolved and today utilize the liquid bars into jewellery. The manufacturer is
on the commodity, it can be treated as ‘margin risk’ which for a producer is on benchmarks to trade on the exchange worried on the procurement price and
a “procurement commodity risk” or the risk of falling prices, and consumers and hedge the commodity price risk sale of the domestic bullion. To manage
“tradable commodity risk”. Procuring on rising prices. using derivative products. Exchange this exposure, the manufacturer may
risk is more focused towards the physical traded derivatives has its advantages think of hedging the procured gold bars
supply chain side of the business whereas Corporates exposed on the procurement of transparent pricing, standardised with hedging contracts that are available
tradable risk is on the financial risk & side of the value chain initially assess contracts and no default risk. To a large on exchanges such as MCX. This will help
hedging of the business. the feasibility of reducing the impact of extent Indian corporates continue to the manufacturer reduce the volatility
participate in the over-the-counter (‘OTC’) and optimize costs on the procurement

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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

side while passing on the cost of hedging and sale is arrived at, a net exposure
to the customer. Secondly, for the sale approach can be adopted, which reduces
price to be achieved on the jewellery the overall risk on the manufacturer with
products - the manufacturer can hedge respect to bullion price fluctuations. Price
this exposure with bullion futures or risk is therefore optimized by reducing
options available from exchanges like the overall exposure using the net
MCX. Given that the benchmark price exposure approach as well as the ability
will be the same with small variations in of passing on the cost of hedging to the
the way the end price for procurement customer at the time of sale.

Example: A natural gas marketing company

Domestic
Procurement

Natural Gas
marketing company

Imports

P1

Price risk arises when:

P1 (Natural gax benchmark + fixed spread)

As an example natural gas marketing approach to a combination of risk and cost

companies these days structure their deals based approach for the corporates is the
on a formula pricing to attain physical gas real game changer. Corporates manage
in storages on a seasonal contract so they procurement pricing by ‘opportunistic
can utilize the seasonal benefits of lower hedging’ on international and domestic
prices and withdrawals at higher prices i.e. exchanges based on the management’s
managing the procurement price of the view of the market and operate with
physical gas being purchased. Hedging of pre-defined market risk levels on open
the total quantities on the exchanges are positions. Hedging instruments like
then performed based on the company’s futures, swap and options play a big part
risk appetite. in offsetting risk on commodity price
fluctuations.
Although cost management by fixing
prices is an important driver to manage
prices, such companies have started
to focus more on risk management &
hedging of these prices. The gradual
shift from the above only cost managed

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 A manual of hedging commodity price risk for corporates

4. What is Commodity Commodity Price Risk Hedging –

Origins
Hedging comes in various forms. Early
Commodity Price Risk Hedging –
Methodology
An example of Hedging using Options -

Price Risk Hedging?

U.S. commodity (grain) merchants
concerns to ensure buyers and sellers A company needs to buy aluminium as a
purchased the produce with a certain raw material – the company is exposed
fixed future price resulted in forming the to the risk of price increasing at a certain
forward contracts market. This acted as future date i.e. commodity price risk on
a hedging instrument. There concerns procurement. As a result, the company
were still taking undue credit risks. The may decide to buy a plain vanilla call
Hedging – A brief overview Hedging can be performed by taking a issue was resolved by the establishment option to hedge this exposure for that
Hedging is a method of strategically using long or short position against the asset or of the Chicago Board of Trade (CBOT) tenor. As the prices are rising, they have
financial instruments to offset the risk of physical product. Long hedge position is in 1848 which provided a centralised to pay more for the aluminium raw
any adverse price movements. Hedging a strategy taken by generally producers location for standard contracts to be material to the producer although this
plays a crucial role in the industry today or manufacturers of the commodity to traded. This lead to the concept of loss is offset by the gain they will realise
for proper risk management and to protect from the prices going up in future organised financial commodity hedging on the long call aluminium option. Overall
protect shareholder value. Companies are when they have to source the asset at and the futures market. impact will be purchasing aluminium
assessed by shareholders and investors a future price, whereas short hedge at a certain price which the company
on the basis of how strong their hedging is taken when you are already owning Since the advent of the exchange had envisaged.
strategy is. Derivative instruments such the asset and have to protect from the and development of technology the
as forwards, futures, swaps and options prices falling in future. In both cases the financial market place for hedging In the commodity markets, some of
are examples of some of the instruments hedge will offset the loss of rising & falling has grown immensely. Hedging has the financial instruments available
used by companies to mitigate the risk markets and will protect the company become an important topic for overall as hedging instruments has been
and hedge the physical positions/asset. from having diminished margins. risk management strategy of the summarized in figure 6.
organization. Although hedging was the
primary reason initially for development
of trade, we have had speculators
entering the market place. This has
additionally fuelled liquidity and helped
the derivatives market grow.
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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

Figure 6: Typical financial/ derivative instruments available to hedge commodity price risk. Future contracts are typically the Commodity Price Risk Hedging – Hedging – Parameters to Consider
most widely used financial/ derivative instruments Markets Liquidity management and working
Managing commodity price risk is capital are of paramount importance for
unavoidable for companies who have corporates. A company’s business plan
to create a niche in this sector. Every becomes difficult to sustain when
commodity/commodity group brings it depends largely on working capital.
its unique challenges. For example Hence outlay of capital and cost of
crude oil and petroleum products have hedging is one of the most important
Managing commodity risks by hedging liquid benchmarks and products both in factors for corporates selecting these
international and domestic exchanges, derivative products.
whereas most petrochemicals don’t
have developed global benchmarks. Another important point for corporates
Essentially depending on the commodity, to consider is the payoff of the
certain strategies need to be planned and hedging instrument. Depending on the
executed to manage price risk. Most of compatibility of the commodity and the
the commodities these days are traded magnitude of hedge payoff corporates
in international exchanges like ICE, CME, usually select the product.
NYMEX, and LME – while in India, many
Fixed price commodities are traded in domestic Additionally, the liquidity of the traded
swap/ Three way Zero cost Plain vanilla exchanges like the MCX. One can also derivative product becomes an important
Basis swaps
futures participations collar call option trade on the over-the-counter markets parameter for a corporate. A highly liquid
contract using forward contracts either with product – that is a derivative product
international or domestic counterparties. displaying significant trading volumes
on the exchange will be cheaper and
For Indian companies, the Reserve Bank easier to execute. Corporates will also
of India (‘RBI’) has formulated certain look at domestic exchanges for similar
regulatory guidelines through the Master liquid instruments. There are cost and no
Direction reference no. RBI/FMRD/2016- currency risk advantages for corporates
Hedging performed in an efficient way The company can hedge against any 17/31 and the FMRD Master Direction No. using domestic exchanges.
can lead to real value addition to the price fluctuation by opting for a listed 1/2016-17. The guidelines for example
company, but there are risks associated fixed price swap or futures contract. state that Indian companies cannot hedge Basis risk also becomes an important
which should be carefully considered The fixed price swap/ futures contract commodities like gold, silver and platinum consideration for corporates when they
and monitored. Tenor of the hedge is an guarantees a fixed price of material (e.g. on international exchanges unless specific consider certain futures to hedge with.
important part. Corporates should revise metal) over a predetermined period approval has been obtained from the RBI. Paper based futures can differ to the
the hedges closer to expiry. Liquidity and of time. The company locks in a fixed physical benchmark price on a difference
transparency of the instrument being used price on a fixed volume of material Although international exchanges have in grade, so a fixed spread is created.
for hedging is another. This will have an (e.g. metal in an automobile industry) highly liquid benchmarks, domestic
effect on cost of hedging. over a predetermined period of time exchanges have risen in stature. For Finally, most paper based markets
by purchasing a fixed price swap from example – the MCX provides hedging settle on a net basis, and at times this is
Another example: For an automobile the OTC counter party or by taking long contracts for a variety of bullion, base based on price assessment rather than
manufacturer - the material costs positions in futures on an exchange. metals, agro-commodities, and energy traded price, there could be convergence
amount to greater than 50% of the The swap price will reference LME (other markets. Indian firms have also turned to risk vs the physical market. Significant
company’s revenue. Pricing of material pricing benchmark used for physical local exchanges to hedge risks and take convergence risk can enhance basis risk
costs is directly linked to fluctuations in pricing). At the end of each period, the advantage of cheaper costs compared to a point where the hedging program
commodity prices. Therefore, one of the settlement price (as reported by LME) is with international exchanges. Also becomes unviable which are lesser when
key objectives of this company would compared to the swap price when Indian companies participate in trading on established exchanges trading
be to lock in prices for a commodity at a international exchanges, they additionally liquid commodity derivatives.
pre-determined fixed price either through If the settlement price > the swap/ get exposed to currency fluctuation
exchange based derivatives or by arriving futures price, hedging counter party risks. As a result, domestic exchanges
at a fixed price procurement contract with pays company the difference between such as MCX provides contracts that
the supplier – the latter being difficult the settlement price and the swap price. are denominated in rupees to enable
to usually achieve especially where the However, if the settlement price < the market participants to focus on hedging
underlying commodity price volatility swap price, the company pays the hedging commodity risk only.
is high. counter party the difference between the
swap price and the settlement price.

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5. Methodology of Hedging
Figure 7: Value chain of a gold jewellery manufacturer

Commodity Price Risk A Purchase of gold from local bullion dealer by fixing price derived from international gold benchmark

B
Value chain analysis and stages of the Company to understand its value
Full payment made to the supplier at the time of taking delivery of gold bars
considering entering into a hedging chain with respect to its exposure to
arrangement commodity price fluctuations i.e. on
Value chain analysis is typically defined the procurement and storage of its raw
as ‘a process where a firm identifies its materials to the storage and sale of

C
primary and support activities that add finished goods.
value to its final product and then analyze Processing of gold bars and manufacturing of ornaments/ jewellery
these activities to reduce costs, increase Taking the example of a domestic gold
profitability or increase differentiation’. jewellery manufacturer, as given above,
However, in the case of commodity price the value chain can be summarized in the
risk management, prior to undertaking following diagram:

D
the hedging activities, it is important for Pricing of gold for sale to customers across the showroom network based on local market
linked price derived from international gold benchmark

E Collections from customers across the showrooms

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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

The above value chain explains that domestic market. However, the demand •• Sale of jewellery is mainly procurement of gold and sale of
the Company sources its gold from for gold is highly price elastic leading done across the network of gold jewellery, in India, the Company
local bullion dealers – where the price to difficulty in estimating demand and showrooms of the Company in the is required to use exchange based
that is fixed at the time of procurement fixing of gold price. Moreover, fixing of domestic market derivatives such as futures and
is derived from international gold price for gold sales is undertaken based options to hedge the gold price risk.
benchmark prices – which is usually on local benchmarks that are derived
•• The demand for gold is highly
quoted by the London Bullion Market from the international benchmark prices. Key considerations for hedging
price elastic leading to difficulty in
Association or ‘LBMA’. Therefore, this part of the value chain price risk
estimating demand and fixing of
analysis indicates that the procured gold The value chain analysis provides the
gold price
Let’s consider stages A to B – in this case has been priced in and now profitability summary of the need to hedge price risk –
the price is fixed at the time of order with can only be realized if the fixed sale of however given regional market dynamics,
02. Pricing environment:
the bullion dealer, therefore the Company gold is higher than the procured price of an additional step is required so as to
does not face any exposure to commodity gold. As a result, the Company may have •• Gold price fixing of purchases takes assess the ability to hedge the price risk
price fluctuations till the time it fulfils a potential need to enter into another place on the basis of international of the commodity under considerations.
the payment for the purchase. Another hedge during the sale order time to benchmarks Key considerations for this assessment
inference that can be made is that usually protect itself from the risk of depreciated include:
•• Fixing of price for gold sales
this would be a relatively low lead time prices of gold. 01. Available markets/ indices: Trading
is undertaken based on local
from order to payment – typically a cash markets (exchange-based/ over-the-
benchmarks that are also usually
and carry arrangement. However, if If we consider the stages D to E – this has counter) available for hedging the
derived from international
there was a case where the price at the the final impact based on the demand price risk of the commodity in India
benchmarks
time of order was indicative for purchase exhibited by the end customers. The sale or in special cases, in international
and not fixed, then the Company would of jewellery will be based on the date on •• The Company therefore operates markets as well as the feasibility
have been exposed to commodity price which the customer decides to purchase in a pricing environment where it is of each market to complement the
fluctuation until the time of fulfilling the the jewellery – hence there may be a lag not possible to avoid the exposure exposure profile of the Company for
payment for that purchase – and if the at the time of maintaining the priced in to commodity price risk hedge consideration.
price of gold appreciated from order sale of jewellery at the showroom to the
to payment, that would entail a higher price at which the customer ultimately 03. Business impact: 02. Hedging instruments: Hedging
purchase price onto the customer. purchases the jewellery. However, instruments available within each
•• The difference in timing of fixing
Therefore this part of the value chain given the difficulty in estimating the of the identified trading markets
gold prices for purchases and for
analysis indicates the potential need time of purchase of customers, hedging (futures/ options/ swaps etc...) as
sales leads to a risk on business
to consider a hedging arrangement to tenor may not be extended hence as well as the feasibility of each hedging
margins for the Company on
protect the Company from gold price a mitigation strategy, the Company instrument to complement the
account of depreciation in
fluctuations. focuses on streamlining its inventory exposure profile of the Company for
gold prices
and distribution arrangements so as hedge consideration.
Let’s consider stages B to C – in this case, to minimize the lead time of supplying •• The Company may not be able to
the Company has procured its gold and the showrooms with the priced in gold successfully pass-on this market 03. Exchange trading volumes: Trading
stored it in the vault until it’s time for jewellery up to the time of purchase by price risk to its customers since the volumes prevalent in such hedging
processing and converting the gold bars the end customer. pricing and business environment is instruments at the identified
into ornaments or jewellery. The time highly competitive exchange trading markets so as to
for storage in its inventory continues Therefore, value chain analysis assess the Company’s exposure vis-à-
•• Thus, the Company is exposed
to expose the Company to gold price summarizes the following: vis liquidity and risks thereon.
to the volatility in the gold prices
fluctuations therefore having an impact 01. Business value chain:
which can significantly erode the
on the inventory value of procured gold. 04. Pricing considerations: Price
•• The Company is involved profitability of Company
Therefore this part of the value chain discovery methodology and quality
in processing of gold and
analysis indicates the potential need of the underlying commodity of the
manufacturing of jewellery and 04. Price risk considerations:
to evaluate the tenor of the hedging derivative offered by the exchange
directly selling the finished products
contract to protect itself from gold price •• The Company may be required to along with the trading units so as
through its showrooms.
fluctuations. hedge the prices of gold to be sold to align with the Company’s pricing
•• The Company procures gold on at commercially acceptable levels mechanism and benchmark price
Let’s consider stages C to D - Sale of cash and carry basis from local without creating additional basis and
•• Given that the Company cannot
jewellery will typically be done across bullion dealers where the price is other risks.
alter any of the business dynamics
the retail distribution network of also derived from international
around the physical business, i.e.;
showrooms of the Company in the benchmarks

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 A manual of hedging commodity price risk for corporates

05. Margin requirements: Margin Lifecycle of a typical commodity price

SNo Commodity price risk & hedging stage Key activities
requirements pertaining to initial risk and hedging framework
margin and variation margins (for After assessing the business value chain 1 Exposure collation and aggregation Identification and recognition of commodity exposures based on type for
example: SPAN based margin v/s to arrive at the price risk considerations procurement or sales budgeting and maturity profile of the procurement/ sales
percentage of contract value for and after assessing the considerations
2 Risk quantification and assessment of Quantification of risk based pricing and market movements and assessment of
trading at the MCX) based on the for hedging the underlying commodity
potential impact factors affecting off-set between hedges and underlying exposure
contract size and volatility of the that’s causing the price risk issue to the
prices of the underlying commodity Company, the next stage effectively 3 Decision support & setting hedge ratios Limits to market operations and monitoring for the same and setting of the hedge
under consideration. forms the main part of the commodity ratios (Hedge ratio = Hedge value/ Exposure value) based on risk appetite
price risk and hedging framework.
4 Price fixing arrangements Lock-in of purchase/ sales price to minimize impact on inventory value and
06. Regulatory considerations:
structured margins
Regulatory guidelines applicable The following diagram provides the
for undertaking hedges for the summary of the key stages of the 5 Re-balancing instrument mix Decision support to re-balance hedging instruments and pricing options based on
selected hedge market (such as any commodity price risk and hedging market movements and hedging strategy
commodity exchange) and hedging framework. Each stage of this framework
6 Hedge transaction execution Entering into hedge transaction using exchange-traded futures/ options (or
instrument/s. in this diagram is explained in the
OTC hedging instruments), establishing hedge rationale & basic documentation
subsequent table.
support and linking hedges to underlying exposures

7 P/L and MTM computation Mark to market (i.e. market value of hedge and exposure on a specific date) of
hedges & exposures to track performance on an ongoing basis along with profit &
loss computations to assess extent of off-set from underlying and hedge positions
Figure 8: The stages of the commodity price risk and hedging framework
8 Hedge performance assessment Assess hedge performance based on degree of offset achieved on the underlying
exposure along with other performance and risk indicators

Key documentation requirements for •• Risk management principles of the

Risk quantification executing the commodity price risk Company i.e. the salient philosophy
Price fixing Hedge transaction Hedge performance
and assessment of and hedging framework and guidelines for facilitating the
arrangements execution assessment
potential impact To enable the execution of the commodity commodity hedging activities
price risk and hedging framework, the
•• Authorized markets and
Company is required to maintain the
hedging instruments i.e. the
following documentations:
acceptable hedging markets (ex.
01. Commodity price risk policy – The
List of exchanges) and hedging
commodity price risk policy provides
1 2 3 4 5 6 7 8 instruments (ex. Futures and
the principles and guidelines for the
options) that the Company has
Company to facilitate its commodity
authorized to undertake in its
hedging activities. This is usually
hedging activities
signed-off by the Board of Directors
of the Company. Salient features of
02. Standard operating procedures –
the policy include:
Key operating guidelines for
Exposure collation Decision support & Re-balancing P/L & MTM
•• The risk appetite of the Company undertaking the hedging activities
and aggregation setting hedge ratios instrument/ mix computation
with respect to commodity price risk which are supplemented with the
i.e. the degree of risk the Company internal controls maintained within
is willing to expose its business the Company.
margins to commodity fluctuations
– this also determines the required 03. Reporting framework – MIS &
hedge ratio to be maintained by reports to be provided to various
the Company levels of the Company’s management
with respect to the exposures,
hedges, hedge performance and
other aspects required from the
Company’s commodity price risk and
hedging framework.

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6. Using Futures and

Figure 9: Typical pay-off structure of a futures contract

Options to Hedge
Net Price

Example: A Company that

Commodity Price Risk

sells finished goods where
Company receives the underlying commodity
Difference is linked to a specific pricing
benchmark – and enters
Company into a futures contract
pays difference

Futures contract commodity exchanges can be physically Swap/ Futures contract Price
A futures contract is a legal agreement, settled upon contract maturity or is cash
generally prescribed by a futures settled (as mandated by the commodity
Market Price
exchange, to buy or sell a particular exchange). The pay-off structure is linear
commodity or financial instrument at a with respect to the market price at the
predetermined price at a specified time in time of settlement. Opportunity Gain Opportunity Loss Hedged Unhedged
the future. Futures contract executed in

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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

Example: A gold manufacturer are traded. For instance, the contract Net Price
Put options can be
specifications of a typical gold futures
•• The Company locks in a fixed price compared to buying
contract in MCX can be referred to the
on a fixed volume of gold over a insurance. The Company
following link: https://www.mcxindia. com/
predetermined period of time by is protected against fall in
products/bullion/gold
taking short positions in futures on the price, but participate fully
commodity exchange like MCX. when price is rising
Plain vanilla option contract Company
•• The futures price of the MCX futures An options contract is an agreement receives difference
contract reflects the Indian spot price, between a buyer and seller that gives the Swap Price
} Premium paid
which typically has a high correlation purchaser of the option the right to buy
with COMEX Gold futures as India is or sell a particular asset at a later date
a ‘price taker’ for Gold. At the end of at an agreed upon price. Typically the
each period, the settlement price (as underlying of an options contract listed on Buy Put Strike
reported by MCX) is compared to the an exchange will be the futures contract Market Price
future price. for the same commodity. Option contracts
are also termed as call and put options Opportunity Gain Hedged Unhedged
•• If the settlement price < the futures
based on the position of the market
price, the Company gains the difference
participant when undertaking the contract.
between the future price and the
settlement price. Example: A gold manufacturer
Call option – A call option is an option
•• If the settlement price > the futures contract between two parties where the •• A put option available in MCX effectively
price, the Company is at a loss on the buyer of the call option earns a right (not creates a floor price in exchange for an
difference between the settlement an obligation) to exercise the option to option premium. This premium reflects
price and the futures price. buy a particular asset from the call option the likelihood that the option will be
seller for a stipulated period of time. Once exercised. In other words, the farther
Key advantages the buyer exercises his option, the seller the strike price is from trading levels,
has no other choice than to sell the asset the lower the amount of premium paid
•• Exchange traded hence no upfront.
at the strike price at which it was originally
counterparty risk exposure
agreed. The buyer expects the price to •• The put option will reference to the
•• Standardized contract applicable to all increase and thus earns capital profits. underlying MCX gold futures price.
market participants
Put option – A put option is an option •• At the end of each period, the price
•• Transparent pricing as per exchange of the underlying is compared to the
where the buyer of the put option earns
quotes option "strike" price.
a right (not an obligation) to exercise his
•• Contract can be closed out prior to its option to sell a particular asset to the •• If the price of underlying < the strike
maturity put option seller for a stipulated period price, the Company can either square
of time. Once the buyer of put exercises of the Options position and profit from
Key disadvantages his option (before the expiration date), rise in value of Option, as with the fall
the seller of put has no other choice than in gold prices, the premium for gold
•• Standardization of contract may not
to purchase the asset at the strike price put option will rise. Given that option
align well with the Company’s exposure
at which it was originally agreed. The contracts traded in India are primarily
profile with respect to tenor of hedge
buyer of put expects the value of asset to European based options, on expiry of
•• May create basis risk where there is a decrease so that he can purchase more the options, the put buyer can exercise
difference in the pricing benchmark quantity at lower price. his option, which will result in creating a
used in the future contract against sell position in the underlying futures at
the pricing benchmark considered for Strike price is the pre-determined price at the ‘strike price’, which can be squared
physical trade by the Company with its which the buyer and seller of an option off at the current market price, to
suppliers/ customers agree on a contract or exercise a valid and realise profits.. This payment offsets
unexpired option. While exercising a call lower prices in the physical market.
•• Involves continuous monitoring on
option, the option holder buys the asset
margin maintenance •• If the settlement price > the strike price,
from the seller, while in the case of a put
option, the option holder sells the asset to the purchased option expires and is
Contract specifications of commodity rendered worthless. But the Company
the seller.
derivative contracts can be found on the benefits from higher prices in the
websites of the exchanges where they physical market.

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7. Benefits of Hedging For those companies that are exposed to

the same pricing benchmarks on its costs
and revenue side, using a net exposure
earlier is now moved away from the P/L
thereby adding additional stability to
the P/L volatility attributed to fluctuating

Commodity Price Risk

approach in its hedging program, if commodity prices. However, it is essential
done correctly, helps mitigate the overall that the hedge-exposure relationship is
exposure to fluctuating commodity price based on offset and not on the same side.
with the net exposure being hedged –
therefore additionally protecting that Cost benefits
portion of the impact of the exposure Hedging the commodity price risk using
Cash flow benefits One of the advantages of hedging from fluctuating commodity prices. exchange traded derivative contracts
Working capital is the essence of any commodity price risk is the ability tends to lower the cost of hedging as
business and managing cash flow is a to minimize cash flow fluctuations P/L offset and accounting benefits compared to undertaking an over-the-
challenge for almost every company. attributed by commodity price The advent of Ind AS (as explained in counter derivative contract for the
Business owners as a result stay vigilant movements. Hedging insulates the the subsequent section) has allowed for purpose of hedging – especially where
in order to keep the business financially company from such volatile price Indian companies to realize the impact the traded derivative contract is highly
viable. Fluctuating commodity prices movements, and is poised to stabilize on their hedges and exposures on the liquid. This is largely attributed to the
especially on a significant part of cash flow volatility by creating an P/L thereby offsetting the impact on the lower spreads on the quoted derivative
the value chain can cause cash flow offsetting impact in case of commodity P/L – which as a result helps the company prices as compared to the over-the-
fluctuations in the business. Hence, price fluctuations – with the aim to to reduce P/L volatility attributed to counter market which do not require any
forecasting and protecting future almost achieve a zero-sum game for the fluctuating commodity prices. additional negotiation (again as done
cash flows become vitally important. commodity exposures covered under on the over-the-counter market) and
Difficulties in liquidity as a result force that hedge. Furthermore, Ind AS allows for hedges the true cost is primarily attributed to
the company to undertake short-term undertaken against highly probable margin maintenance. This is essential for
financing arrangements to address the forecasted exposures – which are off those companies that do not have the
liquidity deficit – which increases the balance sheet items, to not have their necessary ability to pass on the costs of
costs to the company. MTM impact realize on the P/L – till the commodity price fluctuation and hedges
time this exposure is recognized as on to the customer – due to competition
a balance sheet item. Therefore, the and other market pressures.
lop-sided impact on hedges as done
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8. Understanding exposure with the hedging instrument.

Moreover, the ability of the offset on the
P/L was not necessarily achieved through
Financial Instruments and Ind AS 113:
Fair Value Measurement), focus on
hedge accounting is primarily on Ind

Hedge Accounting
the hedging programs leading to a wide AS 109 where a risk component of a
difference between the cash flow impact non-financial item will be eligible as a
v/s the accounting impact from the hedged item, provided it is “separately
hedging program. identifiable and reliably measurable”. This
criteria would generally be met if the risk
Additionally, where hedges were taken component is contractually specified.
on forecasted exposures, companies It is also possible that non-specified
Hedging programs of companies have Until recently, under Indian GAAP, there
were unable to showcase the offset as risk components meet the criteria in
typically evolved with the dual objective wasn’t any comprehensive literature for
the effect of change in the commodity/ some cases. Allowing a closer match
of protection of cash flow margins and accounting for financial instruments.
currency rates on the forecasted between the hedged risk and the hedging
protection of reported earnings against While AS-13 Accounting for Investments
exposure did not show on the P/L being derivative has resulted in more common
price volatility in financial statements. dealt with the accounting for investments
an off-balance sheet item while the effect risk management strategies to qualify for
Over the past few years, as the evolution in the financial statements and related
of change in the commodity/ currency hedge accounting and therefore, lesser
in accounting standards didn’t always disclosure requirements, it did not cover
rates (or MTM) on the hedging instrument volatility (i.e., ineffectiveness) in profit
keep pace with innovation in hedging the classification and measurement of
had to be taken into P/L, especially in the or loss.
strategies and financial instruments, the financial liabilities. While some other
case of MTM loss – therefore creating a
dual objectives of cash flow protection standards covered some other aspects
lop-sided view on the profitability of Example – Contractually specified
and reported earnings protection of financial statements such as AS-11
the Company. risk components - Entity P is a large
tended to be at cross purpose. This led Effects of Changes in Foreign Exchange
manufacturer with an extensive network
to companies that structured hedging Rates covered certain foreign exchange
Upon transition to the new accounting of factories and distribution outlets.
strategies that focused on achieving contracts – however these requirements
standards – Ind AS, with respect Fuel costs are significant. To reduce
either one of the two objectives or at as per the Indian accounting standards
to financial instruments (covering profit or loss volatility, the entity’s risk
times wavering between these objectives. were never as robust as per the
Ind AS 32: Financial Instruments: management strategy allows it to hedge
As a result, stakeholder confidence in International accounting standards. At
Presentation, Ind AS 107: Financial a component of the fuel price risk using
hedging programs was challenged at each that time, it was difficult to establish
Instruments: Disclosures, Ind AS 109: futures and swaps for periods of up
reporting date. the relation between the hedged item/

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 A manual of hedging commodity price risk for corporates Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

to three years. Entity P purchases fuel •• Link each commodity hedge to the Key disclosures for commodity ‘The Company uses various derivative
under a five year contract which specifies commodity price risk strategy - Such price risk financial instruments such as interest
the formula for diesel price per litre. linking has to be done at the inception Disclosures related to hedge accounting– rate swaps, currency swaps, forwards
The amount of fuel to be purchased is of the hedge to prove intention With respect to disclosures under Ind & options and commodity contracts
not specified but vehicles fill up diesel at inception. AS 107 for hedging the commodity price (such as futures and options) to mitigate
as required. The volume used is billed risk in line with the Ind AS 109 accounting the risk of changes in interest rates,
•• Each hedge should be earmarked as
on a monthly basis. In this case, the standard, a company is typically required exchange rates and commodity prices.
a cash flow or fair value hedge at the
diesel price risk component is separately to disclose the following: Such derivative financial instruments
inception of the hedge transaction.
identifiable as it is contractually specified are initially recognised at fair value
Cash flow hedges are those hedges
and reliably measureable. Entity P Significant accounting policies – on the date on which a derivative
where the underlying exposure is not
can choose to apply cash flow hedge Derivatives and Hedge Accounting contract is entered into and are also
yet considered as a balance sheet
accounting for the highly probable Hedge accounting activities are disclosed subsequently measured at fair value.
item while fair value hedges are those
forecast purchase of the first million litres in the significant accounting policies of Derivatives are carried as financial
hedged where the underlying exposure
of fuel during each calendar month. a listed company’s annual reports. The assets when the fair value is positive
has already been considered as a
following components enumerates the and as financial liabilities when the fair
balance sheet item. It is important to
Example – Non-contractually specified various aspects covered in the disclosure: value is negative.
differentiate between the two kinds
risk components - Entity Q purchases
of hedge given that the accounting •• Brief insight on the hedging
coffee of a particular quality of specific Any gains or losses arising from
treatment is different for the two. framework: For example, a company
origin under a contract with the supplier. changes in the fair value of derivatives
In case of cash flow hedges, the may provide an insight such as:
The purchase price comprises (i) a are taken directly to Statement of
differential of the mark-to-market of
variable element that is linked to the Profit and Loss, except for the effective
the hedges and exposures will not ‘At the inception of a hedge relationship,
benchmark price for coffee which is of portion of cash flow hedges which is
enter the P/L but under the ‘hedge the Company formally designates and
a different grade/quality; and (ii) a fixed recognised in Other Comprehensive
fluctuation reserve’ also wide known documents the hedge relationship
spread to reflect the different quality Income and later to Statement of
as ‘Other Comprehensive Income’. to which the Company wishes to
that is being purchased. Entity Q enters Profit and Loss when the hedged item
However, in case of fair value hedges, apply hedge accounting and the risk
into coffee futures to hedge its exposure affects profit or loss or treated as
the differential of the market-to-market management objective and strategy
to variability in cash flows from the basis adjustment if a hedged forecast
of hedges and exposures will need to for undertaking the hedge. The
benchmark coffee price and designates transaction subsequently results in the
be considered within the P/L of the documentation includes the Company’s
it as the hedged item. However, the recognition of a non-financial assets or
Company. risk management objective and strategy
changes in the fixed spread relating to non-financial liability.’
for undertaking hedge, the hedging/
different quality would be excluded from •• All hedges are expected to be cash
economic relationship, the hedged item
the hedge relationship. flow hedges if they are taken against
or transaction, the nature of the risk •• Explanation of the criteria for
budgeted exposures or orders which
being hedged, hedge ratio and how the recognizing the treatment of a hedge
With the advent of Ind-AS and the ability do not reflect on the books of accounts.
entity will assess the effectiveness of as a cash flow and fair value hedge:
of applying hedging accounting under the It is important as part of the hedge
changes in the hedging instrument’s For example, the disclosure for an
Ind AS 109 in a comprehensive manner, accounting strategy to clearly earmark
fair value in offsetting the exposure to aluminium manufacturer may be:
companies now have an opportunity what constitutes a cash flow exposure
changes in the hedged item’s fair value
to align their commodity price risk and a fair value exposure.
or cash flows attributable to the hedged ‘Fair value hedge - Changes in the fair
management strategy with reported
•• The hedge documentation should risk. Such hedges are expected to be value of derivatives that are designated
earnings. Additionally, companies also
necessarily carry the deal rationale highly effective in achieving offsetting and qualify as fair value hedges are
have an added opportunity for reducing
for each deal. Hedge effectiveness changes in fair value or cash flows and recorded in the statement of profit
hedging cost which had to be incurred
testing is required to be performed to are assessed on an on-going basis to and loss, together with any changes
to manage reported earnings. However,
offset principle for hedging – which is determine that they actually have been in the fair value of the hedged item
this will require companies to re-align
left to the discretion of the company’s highly effective throughout the financial that are attributable to the hedged
their existing hedging strategies with the
auditors. Hedge effectiveness testing reporting periods for which they were risk. Hedge accounting is discontinued
underlying fundamental business value
shall be performed by assessing the designated. when the Company terminates the
chain of the company.
cash flow offset from hedges and hedging relationship, when the
underlying exposures. The same hedging instrument expires or is sold,
Accordingly the following principles •• Initial recognition and subsequent
method is required to be consistently terminated, or exercised, or when it no
are typically required to be adhered to measurement of financial
followed irrespective of the hedging longer qualifies for hedge accounting.’
by a Company using the hedge instruments i.e. financial instruments
strategy or type of instrument.
accounting approach: used to hedge commodity, interest rate
and foreign exchange risk. For example,
the disclosure for an oil refiner may be:

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Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates

‘Cash flow hedge - The effective under Ind AS 109. A financial liability
portion of changes in the fair value (or a part of a financial liability) is
of derivatives that are designated derecognized from the Company's
and qualify as cash flow hedges is Balance Sheet when the obligation
recognised in other comprehensive specified in the contract is discharged
income and accumulated under the or cancelled or expires.
heading cash flow hedging reserve.
The gain or loss relating to the Disclosures in Statutory Reports for
ineffective portion is recognised listed companies
immediately in the statement of profit As per the SEBI (Listing Obligations and
and loss, and is included in the ‘other Disclosure Requirements) Regulations,
gains and losses’ line item. Hedge 2015 (Notification dated September 2,
accounting is discontinued when 2015) for commodity price risk, a
the hedging instrument expires or listed company is required to disclose
is sold, terminated, or exercised, or the following in their corporate
when it no longer qualifies for hedge governance report:
accounting. Any gain or loss recognised
•• General shareholder information/
in other comprehensive income and
other disclosures: Information
accumulated in equity at that time
on exposure of the company to
remains in equity and is recognised
commodity price risk and hedging
when the forecast transaction is
activities/ approach. For example, for a
ultimately recognised in the statement
jewellery manufacturer, the disclosure
of profit and loss.’
of commodity price risk under the
corporate governance report may be:
•• Re-classification of cash flow hedges
to fair value hedges: For example, a ‘Disclosure of commodity price risks
company may disclose the following: and commodity hedging activities:
The Company uses financial derivative
‘Amounts previously recognised in instruments to manage risks associated
other comprehensive income and with gold price fluctuations relating to
accumulated in equity are reclassified highly probable forecasted transactions
to the statement of profit and loss in and currency fluctuations relating
the periods when the hedged item to certain firm commitments. The
affects the statement of profit and Company has designated derivatives
loss, in the same line as the recognised undertaken for hedging gold price
hedged item. However, when the fluctuations as ‘cash flow’ hedges
hedged forecast transaction results relating to highly probable forecasted
in the recognition of a non-financial transactions.’
asset or a non-financial liability, the
gains and losses previously recognised Risk Disclosures
in other comprehensive income and A listed company also provides the
accumulated in equity are transferred associated risk related disclosures
from equity and included in the initial affecting the business performance
measurement of the cost of the non- within its annual report – in the Financial
financial asset or non-financial liability Instruments section in the notes to
accounts/ financial statement part of the
report. In case of commodity price risk,
•• De-recognition of financial
a risk disclosure for companies having
instruments: The Company
significant exposure to commodity
derecognizes a financial asset when
price fluctuations will capture this as
the contractual rights to the cash flows
a component of ‘Market Risk’ – usually
from the financial asset expire or it
termed as ‘Price risk’ in their disclosure.
transfers the financial asset and the
transfer qualifies for de-recognition

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Commodity Price Risk Management |
 A manual of hedging commodity price risk for corporates

As per Ind AS 107, providing qualitative Qualitative disclosure

disclosures in the context of quantitative ‘The Company is exposed to fluctuations
disclosures enables users to link related in gold price (including fluctuations in
disclosures and hence form an overall foreign currency) arising on purchase/
picture of the nature and extent of risks sale of gold. To manage the variability
arising from financial instruments. The in cash flows, the Company enters
interaction between qualitative and into derivative financial instruments
quantitative disclosures contributes to to manage the risk associated with
disclosure of information in a way that gold price fluctuations relating to
better enables users to evaluate an all the highly probable forecasted
entity’s exposure to risks. transactions. Such derivative financial
instruments are primarily in the nature
of future commodity contracts, forward
•• Entities are required to disclose the
commodity contracts and forward
exposure to risk and how they arise as
foreign exchange contracts. The risk
well as the risk management objectives,
management strategy against gold price
policies and processes and methods
fluctuation also includes procuring gold
used to measure the risk as part of their
on loan basis, with a flexibility to fix price
Qualitative disclosures
of gold at any time during the tenor of
•• Entities are required to provide a the loan. As the value of the derivative
summary of the quantitative data instrument generally changes in
about its exposure to that risk at the response to the value of the hedged item,
end of the reporting period based on the economic relationship is established.
the information provided internally
to the key management personnel of Quantitative disclosure
the entity as part of their Quantitative Alternative 1: Exposure to one commodity
disclosures
Particulars Value*
•• Additionally, where commodity price
risk is a part of market risk, the risk Total exposure as on March 31, 20xx INR 5,000 cr
disclosure may also include a sensitivity
Sensitivity to net profit at 10% movement 16%
analysis, such as value-at-risk, that
reflects interdependencies between
risk variables (ex. commodity prices Alternative 2: Exposure to two commodities
and exchange rates) and uses it to
manage financial risks – with respect to Particulars Value*
its methods and limitations. Total exposure of commodity 1 as on March 31, 20xx INR 5,000 cr

For example – in the case of a jewellery Total exposure of commodity 2 as on March 31, 20xx INR 400 cr
manufacturer having a significant Sensitivity of commodity 1 to net profit at 10% movement 16%
exposure to gold price fluctuations,
a typical disclosure will look like the Sensitivity of commodity 2 to net profit at 10% movement 5%
following: Or Combined sensitivity of commodity 1 & 2 to net profit 14%
(using value-at-risk)
*Illustrative value for representative purposes only

42
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Disclaimer: This document is made available for the limited purpose of creating
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uncertainties using commodity derivatives. It is not intended as professional
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Tohmatsu Limited

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