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Managing FX risk in the commodities sector

Commodities Sector | HCFX

Scenario

The commodities sector is, by definition, commoditised.

This generally means that with standardised product specifications and quantities, price becomes one of the primary drivers in being competitive in whichever area of the commodities market you are working in.

Our client is not an exception to the rule. So they want to ensure that they are in as good a position as possible when managing all the variables in their organisation so that their margins can be razor sharp.

With fine margins comes heightened sensitivity to risk. So, it’s our job to ensure the risk in the currency side of their treasury operation is as nailed down as it can be.

Understanding

It was clear from the outset that their banking lines were incredibly valuable to them.

And we were clear from the outset that we didn’t need to disrupt their trading with the banks to do our job effectively. Instead, we could sit alongside the banks, but make sure the solution could be applied through all their counterparties – though we’d also take the opportunity to make sure everyone at the table was sharpening their pencil.

Like much of the commodity trading market, most of the business they do is in US dollars, which means they buy and sell in USD.

This then leaves them their profits, which need to be repatriated into Canadian dollars. This of course makes sense given they’re Toronto based.

There is some trading where they are buying in a currency other than dollars and selling in either US or Canadian dollars. This business attracts a slightly better margin, but with that better margin comes FX market risk throwing a spanner in the works.

Like most businesses, the contracts they write come with payment terms, both from the purchase of the commodity and the sale. This means that they have an ‘end to end’ transaction time of anything from two weeks to six months, with this often being caused by delays like cargo being held up for all number of reasons.

Proposal

With the USD to USD business, protecting their expected profit in their functional currency was pretty straight forward. 

They knew what their ‘profit per lot’ or ‘profit per ton’ was going to be and when they were likely to have settled the transaction.

This meant that we could simply book a forward contract on a per transaction basis for them.

We’d build in a one-week settlement window, which gave settlement flexibility at a negligible cost. But if the timelines shifted more dramatically, we could move the contract further for them, with no cashflow implications and minimal impact on their profitability.

The higher margin business brought with it more risk, but also a little more opportunity.

By using a portion of this margin towards a structured FX solution they were able to lock in a known worst-case exchange rate but take advantage of favorable market movements in the time between agreeing the deal and settling the cashflows.

By being fully protected to the downside, but participating in the upside, they’re now able to accrue incremental gains to their margins. This means fewer sleepless nights worrying about where the FX market is going – which to quote a well-known song is “like trying to solve an algebra equation by chewing bubblegum”.

Keeping the banks in the mix was a key requirement for our client and they do this through a combination of giving them the hedges from the ‘same currency business’ as well as in certain instances where there is a cross currency deal, but the market conditions aren’t right for a structured solution.

Implementation

With a small finance team based in one location, getting going was easy.

We started by benchmarking the trades with their banks, to get their pricing standardised. This gave them transparency and peace of mind that their panel of providers, including Hamilton Court, were on a level playing field.

Once this was taken care of, we were able to show our strategic expertise and we began trading some simple outperformance structured solutions.

We benchmarked their outcomes versus an equivalent forward, being clear that it wasn’t about beating the forward every time, but by realising a cumulative gain over time.

Now the team knows who they’re speaking to for what type of transaction and take comfort in us always being able to step in if things get complex.

Outcome

The goal was to optimise on part of a transaction process, and we succeeded.

We also delivered incremental gains to our client’s bottom line along the way.

‘One size’ wasn’t going to fit all in this case, but by breaking their business down into the various transaction shapes we were able to provide a tailored solution for each one.

With fine margins being robustly protected, along with opportunities for enhanced margins with favorable market movements, the business continues to increase its transaction volumes and maintain its profit margin in functional currency.

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