Introduction

A firm must determine whether its hedging strategy is a singular event or part of a broader, ongoing risk management initiative. This decision is often referred to as “rightsizing” a risk management program. Given the dynamic nature of financial markets, a comprehensive risk management strategy necessitates investment in sophisticated systems and the recruitment of experienced traders.

Risk Limits

Risk limits are predefined thresholds that specify the maximum acceptable level of risk exposure for a firm. Several risk limits must be understood and potentially controlled based on the outcomes of the risk mapping process. The below table outlines various risk limits, detailing their purposes and highlighting potential weaknesses associated with each specific limit.

Derivatives

A firm must clearly understand the objectives of its risk management program to evaluate and employ the appropriate risk management programs. Risk management function is regarded as a cost center in many firms, where the aim is to minimize the negative imapacts on the firm. As a cost center, the physical costs of implementing risk management tools will be charged to individual divisions or recorded at the enterprise level by the firm. Alternatively, a firm may view its risk management efforts as a potential profit center, using various tools to enhance shareholder value through a direct contribution to net income.

In many instances, the risk manager will opt to transfer part of a financial risk to the risk management markets. The risk manager can used several risk management tools, also called as derivatives, for this purpose. The most commonly used derivatives for this purpose are listed below.

• Forwards: A customized agreement to exchange a specified quantity of an asset at a pre-agreed price on a future settlement date. The asset can be physically delivered, or the contract may specify cash settlement based on the difference between the agreed price and the current market price.

• Futures: A standardized forward contract traded on an exchange with set terms and subject to margin requirements.

• Swap: An over-the-counter (OTC) agreement where two parties exchange cash flows or values associated with different economic positions until or at maturity. For example, one party might agree to pay a fixed interest rate on a notional amount for a specified period, while the other pays a variable rate. Swaps come in various forms depending on the market involved.

• Call Option: Gives the buyer the right (but not the obligation) to purchase the underlying asset at a predetermined strike price either at maturity (European option) or anytime during a specified period (American option).

• Put Option: Gives the buyer the right (but not the obligation) to sell the underlying asset at a predetermined strike price at maturity (European option) or anytime during a specified period (American option).

• Exotic Option: Includes various non-standard options beyond plain vanilla puts and calls, such as Asian options (based on average prices) and basket options (based on a basket of prices).

• Swaption: Provides the holder with the right (but not the obligation) to enter into a swap at a predetermined future date under pre-agreed terms.

Hedging in Practice

Let’s consider an airline firm, which faces significant exposure to fluctuations in jet fuel prices. Given the competitive nature of the airline industry, the airline firm would want a stability in costs as it cannot easily pass the fuel price changes to customers. Since there is no exchange-traded product specifically for jet fuel, the firm would consider derivatives tied to crude oil prices as an alternative. However, this introduces basis risk as the firm must manage the price differential between crude oil and jet fuel. Many airlines prefer customized OTC products tailored to jet fuel, although this approach involves counterparty risk.

Delta Airlines pursued a unique strategy by vertically integrating their operations. They acquired an oil refinery to gain control over jet fuel prices, aiming to mitigate price volatility. However, this strategy also exposed them to the inherent risks associated with oil refining operations.

Risk managers must carefully weigh these advantages and disadvantages to determine the optimal mix of risk management tools tailored to their specific needs.

Benefits/Drawbacks of Derivatives

Derivative contracts exhibit varied benefits and drawbacks based on where they are traded.

Exchange-Traded: Exchange-traded derivatives are favored by investors seeking liquidity, low transaction costs, and reduced counterparty risk due to clearing through an exchange rather than individual parties. However, they are standardized, which may not perfectly align with a risk manager’s specific requirements for underlying assets, timing, or delivery location, leading to what is known as basis risk. Examples of exchange-traded derivatives include futures and options.

OTC Derivatives: Derivatives contracts traded over-the-counter (OTC) offer high customization potential but can suffer from liquidity issues, higher costs, and significant counterparty risk. While an OTC contract can be tailored precisely to a business’s needs, risk managers must bear the risk that the counterparty may fail to fulfill their obligations, introducing counterparty and settlement risks. Examples of OTC derivatives include forwards, swaps and exotic options.

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