A hedge can be thought of as a sort of insurance policy on an investment or a portfolio. These offsetting positions can be achieved using closely related assets or through diversification. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is purely hypothetical, but even the hypothetical perfect hedge has a cost that subtracts from its gain. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge.

2.3 Eligibility of instruments used to hedge

S&OP processes tend to be underdeveloped or absent because meaningfully integrating the procurement, sales, and supply-chain functions is often complex and difficult. In particular, the different functions may all want to contribute to—or even control—decisions such as inventory levels, purchasing, and hedging. Sales may advocate for higher inventory levels than is necessary to guarantee responsiveness to short-term demand, but procurement may see this approach as a source of additional market risk. For companies to understand their exposure to EBITDA fluctuations through commodity price risks, they must first analyze and investigate the correlations between the prices of feedstocks and their end products. They should then quantify exposure based on projected feedstock supply and end-product sales commitments.

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If you own a home in a flood-prone area, you can protect it from the risk of flooding—hedge it, in other words—by taking out flood insurance. You cannot eliminate the risk of a flood, but you mitigate the financial losses you could incur. Even if you never hedge for your own portfolio, you should understand how it works.

2.3.4 Contracts with fixed and variable pricing

If the agave skyrockets above the price specified by the futures contract, this hedging strategy will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract. And, therefore, they would have been better off not hedging against this Bookstime risk. Similarly, hedge inventory serves as a contingency plan for availability reductions.

Another classic hedging example involves a company that depends on a certain commodity. Suppose that Cory’s Tequila Corporation is worried about the volatility in the price of agave (the plant used to make tequila). The company would be in deep trouble if the price of agave were to skyrocket because this would severely impact their profits. A reduction in risk, therefore, always means a reduction in potential profits. So, hedging, for the most part, is a contribution margin technique that is meant to reduce a potential loss (and not maximize a potential gain).

• However, many companies lack formalized S&OP processes even though the supply chain and sales functions must coordinate their actions.
• If the objective is to minimize income volatility, the conceptual approach of jointly hedging inventory exposures and prospective likely offers the highest probability of success, but only if the appropriate accounting treatment can be applied.
• A hedge is an investment that is selected to reduce the potential for loss in other investments because its price tends to move in the opposite direction.
• An obvious way to mitigate margin volatility is to pass on the cost of feedstock inputs through product prices.
• Therefore, effective inventory management practices, such as demand forecasting, supply chain visibility, and collaboration with suppliers, are crucial to optimize the use of hedge inventory.
• This exercise can help companies test their abilities to withstand scenarios that involve varying volumes and prices for both feedstocks and products (see sidebar “Scenario testing to refine hedging policies and processes”).

Because of the frequency of market activity, the prices of liquid commodities tend to reflect a majority of the information the market has. hedge inventory Whether hedge inventory is necessary depends on the specific risks and market conditions faced by a company. For businesses dealing with volatile commodity prices, foreign exchange fluctuations, or other unpredictable factors, maintaining a hedge inventory can be a vital risk management strategy. It provides a level of certainty by allowing companies to lock in prices for raw materials or finished goods, minimizing the impact of adverse market movements on profitability.