"The most difficult thing is the decision to act, the rest is merely tenacity." - Amelia Earhart.
By now you should be well acquainted with John, the Head of Procurement for Fancy Gizmos. John has normalized commodity risk management for Fancy Gizmo. He has built commodity risk management into a routine business practice and the benefits are well understood throughout the business from the factory floor to the board.
He’s reviewing his daily automated, compliance and risk email from the Forge aHedge risk management system when there’s a strange rap on his office door, like a passcode. Sally, the CFO, sidled in, scanning the room for spies like a secret agent. John wondered what was going on. “Ssh…” she said, “I have a secret to tell you. Whacky Widgets is up for sale and we’ve put in a bid!”
Whacky Widgets was Fancy Gizmo’s main competitor. They had been in the news recently because of severe cashflow problems stemming from failing to hedge the copper price and then panic buying at the top of the recent price spike. They came a cropper from copper, John thought.
“The board sees an opportunity but are worried about further copper price problems if they have a successful bid. They’ve asked me to devise a strategy to mitigate this risk, so of course, I knew just where to come. Here is the Whacky Widgets sales’ projection for next year, but you have to keep this top secret! Let me know when you’re done.”
“The name’s Bond, John Bond, “ John winked conspiratorially, “you’ll have the dossier this afternoon, Moneypenny.” What a great name for a CFO John thought, as he went straight to the Forge aHedge website. He recalled a recent article on different types of hedging instruments, in particular one describing the use of options.
A call option, he had learned, was a derivative that provided protection against prices rising above the option’s strike or exercise price. Option buyers, had the right but not the obligation to exercise the option. If prices declined below the strike price they could simply let the option lapse and buy copper in the spot market at the lower price. If prices rose above they could exercise the option and buy copper at the strike or exercise price rather than the prevailing higher spot prices. This flexibility cost a premium, much like paying for traditional insurance. John recalled there was a further variation on the so called ‘vanilla’ option, called a collar, whereby the premium could be reduced to zero by effectively limiting the amount of downside price advantage whilst still to protecting against higher prices.
He knew the board would not want to pay extra costs associated with the bid to acquire Whacky Widgets, so decided that hedging with collars was the best approach, allowing protection against adverse copper price movements but still providing some participation and enhanced profits if the price declined.
In less time than it might take to put on a false moustache, John had used the Forge aHedge system to upload the Whacky Widget forecast, input several different potential hedging strategies and potential copper price scenarios. Quickly copying the clear visual summary of the strategies he ran a stress test on the future valuations of the selected strategy to understand the potential accounting impact if the Whacky Widget bid failed. He emailed the detailed acquisition hedging recommendation for a strip of collars to Sally with the subject line “Copperfinger Report ;)”.
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