Starting A Hedging Desk
One of the first steps companies take when deciding whether or not to hedge their price exposures, be it metals, foreign exchange, or any other input with a fluctuating price, is to assess the costs of hedging. Most companies considering setting up a hedging system or desk would already have a lot of the internal functions needed to manage the back office side of hedging. A finance team, accounts receivable/payables, legal (or access to legal), and a management hierarchy that could oversee futures trading executions. Therefore, the cost of additional employees required is usually minimal.
Most companies that hedge will have a hedging desk, also known as a deals desk. How many employees are required to run the desk, take orders, execute hedges, and manage positions really depends on the size of the company and the volume of trades, and the time zones that the company operates in. I have built and run a metals hedging desk from the ground up by myself - I’m not saying that to boast but to show that the human capital required to take this important step in mitigating risk is not overly cumbersome or costly. The alternative is to allow physical trading staff to execute hedges directly with brokers. However, from a compliance standpoint, I would highly recommend against this - ideally the risk mitigation aspect of a trade is seperated from the department that is creating the risk in the first place!
There will inevitably be some time cost/actual cost that is required to set up the agreement and paperwork with the broker(s) a company will use to hedge with, but in my experience, this is again minimal. LME brokers need clients so it is not in their interest to have hundreds of pages of legal documents that require huge costs in legal fees just to understand.
The other side of the cost analysis is the actual execution of the hedges and the surrounding finance constraints. If a company doesn’t hedge, its cash flow from purchases and sales is relatively straightforward. They buy material, cash goes out. They finance that material until they sell it to an end consumer and they receive funds against an invoice. Now, there may be some play with payment terms on the purchase and the sale, but in general, that’s the flow.
When you add hedging into the equation, you are creating additional flows. When a trader hedges a physical purchase, they will sell futures, let’s say 2 months into the future. When they hedge their physical sale, they will buy back those futures and the difference in price between futures short and futures long will create either a credit or a debit with the broker. Careful management of these flows is required, especially since most companies are not just hedging one contract per month.
They will need to finance the initial margin on that futures trade, either with a credit line that they may pay interest on, or in cash, either way, this is a cost, albeit a relatively small one in terms of $/mt. They may also face variation margin constraints on their futures trades until they are bought back upon hedging the physical sale. They face the risk of having to finance variation margin in cash until the point they unwind their short futures position. This can be a significant
amount of financing if you are trading copper, nickel, or other high-value commodities where you could realistically see a $1,000/mt or more price increase between pricing a purchase and a sale.
Another cost is the actual commission a company pays a broker to execute a trade on the exchange. Brokers will charge a fee, sometimes a fixed $/mt amount or sometimes a % of the value of the trade, to facilitate access to the exchange. These costs are relatively low but they are still costs that need to be factored into profit and loss calculations to ensure accuracy in trading and forward planning.
Some companies will look at these costs and think that hedging is not worth their time or money. They believe they are doing fine as it is so why change something that’s not broken. Well, most of the time I would argue that it is broken, they just haven’t realised it yet. They may not have endured a significant loss due to lack of hedging, they may deem the time required to hire and train staff on the subject too much of a hassle. Or the metal input to their product may be relatively small compared to the final sale number so they think it not worth even finding out how to hedge. Whatever the reason a company may not be hedging, it is my strong belief that the time required to properly set up a desk, and the cost of executing hedges, should not be a reason a company decides not to hedge. The risk of having a price move against you far outweighs any small cost of setting up and running a hedging desk.
We are extremely lucky that we have such liquid, highly correlated exchanges where we can hedge 99%+ of our price risk when it comes to metals. If a company decides not to hedge because it’s ‘too risky’ - what they often fail to realize is that by not hedging they are actually taking massive speculation on the price. They may not think it affects their overall profit or loss, but given the ease of setup, and access to hedging, I believe it is incumbent on all companies to hedge their price risk where possible. Or at bare minimum have an intelligent conversation about risk and their approach to it, rather than just leaving things purely to chance.
