Commodity Hedging is in Favor with the FASB

October 24, 2017 in Hedging
New FASB hedge accounting standards are beneficial to Pack Creek. This story started to trickle out this summer. The new standards will mainly impact corporates but it is still good to see a compliance issue actually favor business development rather than detract from it.
Bottom line:
  • Complexity of the former rule set forced the majority of corporates to avoid financial hedges
  • The new standards simplify the accounting rules around hedging
  • Expected to cause more companies to start hedging commodities or increase the volume of their hedges
  • Come into effect in 2018/19
See article below:

Commodities Hedging

Aaron Cowan, executive director and global leader of corporate accounting advisory services at Chatham Financial, a global risk management advisory firm, said that while the new standard will provide “a lot of opportunities” for companies, its biggest effect is likely to be on the way that companies deal with commodities risk.

“We’ve seen historically that the punitive guidance in the past was a stumbling block to corporate hedging in the commodities arena,” he said. “We believe a lot more companies will start hedging commodities or increase the amount they were hedging because of the new rules.”

Under the previous FASB hedge accounting standard, companies had to consider the total cash flows associated with the hedged purchases of commodities. That posed a challenge for companies dealing with commodities because the cost can include the cost of fabricating and shipping the commodity. But changes in those components of the cost aren’t reflected in the financial derivatives used to hedge commodity costs.

Cowan compared that to a company hedging interest rates, which can borrow at a rate based on Libor and then hedge that Libor exposure. “Now commodities [hedging] is able to move into that realm, where you can focus on a specific component of the price,” he said.

To date, companies have been much less likely to use hedge accounting for commodities hedging. A benchmark study of the filings of more than 1,500 public companies that Chatham updated last year showed that while 80% of companies that hedged their interest rate exposures applied hedge accounting, as did 90% of those with cash flow currency hedging programs, only 45% of companies that hedged commodities exposures used hedge accounting.

With the arrival of the new standard, companies that have commodities exposures but “let the accounting tail wag the dog may start hedging commodities for the first time,” Cowan said. “Companies that are hedging but in a small way, because they don’t get hedge accounting, will likely increase the hedging they do.

 

What is the best approach to hedging? Systematic vs. Discretionary

October 9, 2017 in Hedging

Part of Pack Creek’s compensation is linked to our ability to beat a benchmark. This value-added trading is at the core of what we offer our commodity hedge clients – when our clients achieve their hedge objectives, Pack Creek earns a performance fee. The better they do, the better we do.  It sounds straight forward but in reality this is a skill based activity that draws from decades of experience and knowledge.  Can this knowledge be systematically coded into a trading algorithm? Perhaps a better question is, should it be coded into an algorithm?

When speaking with clients, this topic of systematic trading comes up often. There is a natural tendency to compare systematic methods to discretionary methods. Driving the conversation is a single theme, “which method produces better performance?”

In the following piece, Cliff Asness and his team at AQR Capital Management tackle the issue.

Here are some highlights:

  • The terms ‘quantitative’, ‘systematic’ and ‘rules-based’ are often used interchangeably; they represent an investment approach that is often perceived to be in direct opposition to what a ‘fundamental’, ‘discretionary’ or ‘stock-picking’ approach may be.
  • While it is fair to contrast systematic and discretionary approaches, we stress that they are not opposites. Indeed, both systematic and discretionary managers pursue the same objective and both can be fundamentally-oriented. That is, they can use very similar inputs, but in different ways, to try and achieve the singular goal of improving investment performance.
  • Neither systematic nor discretionary managers are inherently superior. Each has the ability to deliver good investment outcomes and, as we show in the data, there is little evidence that one approach is better than the other.
  • The historical correlations between excess returns from systematic and discretionary managers are low, which suggests that many investors may benefit from incorporating both types into their allocations.
  • Importantly, historical correlations among systematic investors are also low, as low as they are among discretionary investors, suggesting that the notion that ‘all quants trade on the same signals’ is misplaced.