Every industry has its own risks, mostly generated by volatilities or events that are inherent to that industry. These are generated by the volatility of commodities or by events that are especially relevant to that industry. Consider for example, a car manufacturer that needs to buy a certain number of tons of aluminum to fulfill its production needs every month. In some cases they directly purchase from an aluminum producer, and in some others from a supplier in the form of aluminum wheels, aluminum engines, cables, etc. The car manufacturer in our example is, either directly or indirectly, short aluminum; this exposure implies that an increase in aluminum prices will generate higher costs and a reduction in their profit margin. The firm can decide to assume that risk, in that case it could benefit from decreasing aluminum prices and suffer in case they increase, or to mitigate the risk through some hedging strategy. A first and important step to analyze this situation is assessing who is the natural owner of the aluminum volatility.
Let’s start by considering the easiest situation; if the car manufacturer needs to purchase plain aluminum to produce some parts of the car, they essentially have a direct short position in aluminum, and that exposure can be easily hedged in the London Metal Exchange (LME) purchasing aluminum futures, swaps, or call options. There is plenty of literature on how to hedge these exposures so we are not going to discuss this matter in this post (the “Videos on Hedging” section of this webpage shows videos –in Spanish- on this matter).
Let’s now consider a more complex situation; the purchase of aluminum wheels. In this case the company needs to purchase a certain number of aluminum wheels from its wheels supplier, so, strictly speaking, the firm is short aluminum wheels, not aluminum, so the exposure to the traded commodity volatility is indirect. We are prepared and well equipped to hedge exposures when we have a financial market and derivative contracts on the good we need to buy or sell, but in this case we do not have a market in which we can buy futures, swaps or call options on aluminum wheels, so we need to find a better alternative for hedging that position.
If we could prove that the prices of the wheels have a perfect positive correlation with the aluminum prices, and that that perfect correlation will hold in the future, then we can treat this exposure as a plain aluminum short position and hedge it in the aluminum futures and options market in the LME. But this situation of perfect correlation is unlikely to happen. I would argue that it is almost impossible to find in the economy. Let’s see why. The pricing equation of the wheels producer is something like this:
Wheel Price: f (aluminum price, energy, salaries, other costs, profit margin, e)
As we can see, the price at which the supplier will be willing to sell the wheels to the car manufacturer is a function of several variables, most of them not directly controllable by the firm. This means that it is possible that in some periods of time aluminum prices and aluminum wheels prices might take different paths; i.e. with increasing aluminum prices we might see flat or decreasing wheel prices. This is quite common and happens because the variables in the pricing equation above have different volatilities and interactions. This happened in the aluminum cans industry in the beginnings of the nineties, when the can manufacturers in their quest for volume where charging prices that where non-correlated with the aluminum prices. In a similar fashion during several periods of the nineties, soybean oil prices where non-correlated (and during some periods of time also negatively correlated) with soybean prices, reflecting the potential dissociation between variables that we might assume highly correlated.
So, the problem is how to hedge a position in a product that is not a commodity and does not trade in the financial markets. The solution to this problem is to decompose the exposure and assign each portion of the risk to whoever should be its right owner: most suited to either assume it or to hedge it in an efficient manner.
The car manufacturing firm could ask the wheels suppliers to fix wheel prices through a forward contract for, say, a full year, in that case they would generate a long position in wheels that would offset its natural short position. That would be a nice hedge for the exposure, but at the cost of asking the wheels supplier to assume a risk he might not be suited to assume. By selling wheels at a fixed price the supplier is assuming the potential volatility of all the variables in its pricing equation. In theory the wheels producer should go to the financial markets and buy a hedge for whatever variable whose volatility it is not prepared to assume. The problem is that this is not always the case, and often times the fixed price contract results in an exposure that cannot be sustained by the firm and, as a result, the whole supply chain might be negatively affected. An increase in aluminum prices would affect our wheels supplier stuck with a fixed output price, and he might face significant problems, resulting in decreased product or service quality, financial distress, or even bankruptcy. None of these outcomes is desirable for the car manufacturer.
In order to avoid such a bad outcome the car manufacturing company willing to eliminate its exposure to wheel price volatility, could sign a contract with its wheel supplier in the following terms. The fixed price will be referred to all pricing components excluding aluminum prices. In other words, the pricing contract will be designed on an equation of this form:
Wheel Price = Aluminum Spot Price (LME) + $xx
Where Aluminum Spot Price (LME) is the spot price of a pre-specified date, and $xx is a fixed amount of money for the whole period (in this case a year) that would cover all the other terms of the supplier’s pricing equation. Under this contract, the car manufacturer will be charged, whatever price the aluminum is trading on the LME, plus a fixed amount of $xx for the wheels. This means that the firm has changed from a short position in wheels (that cannot be hedged in the LME), for a short position in aluminum that could be easily hedged through any derivative contract in the LME. This decomposition allowed the aluminum price risk to be assumed by a firm that, in this case, was better suited to transfer it. It is quite obvious that the wheel manufacturer could have done this risk decomposition on its own! This is entirely true, but assumes that every firm has the same capabilities of identifying and managing risk exposures. And this is not necessarily true. The ability to manage risks is widely volatile across firms, and there is a significant value in allocating the risks to its natural owner.
This same analysis could have been done up or down in the supply chain, from the supplier to its own supplier or from the client to its own client. In this same example we focused on the aluminum prices exposure, but we could have also discussed the possibility of who is better suited to assume the energy prices exposures as well…
Every industry or value chain is affected by several risks whether we like them or not. It is essential to allocate them to whoever is most efficient in assuming them. This will not only improve the efficiency of the industry as a whole, but of the firm that is able of assigning the risks to its right owners eliminating the undesired volatility. This same discussion applies to almost every industry, and has higher value in those industries in which there is a larger asymmetry in the risk management capabilities.
