Margin risk management - redefining your hedge policy

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Business risk is all about uncertainty associated with future business viability. As such, it takes many guises. Operational risk involves uncertain business viability due to deficiencies in its operations, market risk is associated with uncertainty due to financial market movements, while credit risk relates to the potential for default by counterparties on their obligations. While most risks usually fall into these categories, a framework for describing risk usually takes a quantitative form. As business viability is almost entirely a function of profitability, risk can be expressed in terms of margin variability. When adding a time, driver or probability of occurrence dimension to risk, a so-called exposure profile results.

By its nature, a business's future viability is uncertain: 'no risk, no return'. However, stakeholders usually have fixed appetites for risk: premiums charged for putting capital at risk are directly related to risk appetite. A hard definition would be a stated policy of not having operating margin decrease by more than 5% due to input material increases. Defining risk appetite in terms of event probability is a soft definition: operating margins are not to decrease by more than 5% due to market-variable changes with probability greater than 1%.

It could therefore be argued that risk management is the process by which risk appetite and actual risk exposure are aligned. Reducing margin variability to within limits determined by risk appetite should be the measure by which the success of a hedging policy is determined. In other words, hedging is the process by which margin variability - and consequent business risk - is reduced to limits determined by shareholders. A hedging policy's aim is commonly misunderstood as margin maximisation but this is a convolution of the concepts of trading and hedging.

Risk management philosophies

The understanding of a market risk profile, and the management of it, is very much a function of one's risk philosophy. This could be characterised as follows:

- A holistic approach - the whole is greater than the sum of the parts. Holism requires thinking and reasoning within an interconnected, multi-dimensional framework. It has the potential to provide the most realistic, market-consistent view of risk profiles being run. Holistically viewing a market risk profile would recognise and test the correlation present in the input/output product prices, facilitating in the choice of appropriate risk mitigation structures.

- Risk reductionism - the whole is nothing but the sum of the parts. Reductionist views are easy to understand and communicate while being highly informative about conditional aspects of a greater risk picture (i.e., with everything else remaining constant).

Often, interconnectedness explains more of the risk profile than the behaviour of individual components. In such situations, reductionist views of risk are less than worthless. They are plain dangerous.

The benefits of a good risk policy

A good risk policy then is one that aims to synchronise risk exposure and risk appetite. The benefits of having one, and its efficient implementation, include:

- an enhanced rating both in terms of equity and debt due to a decreased boom-bust earnings character;

- improved capacity for, and better realisation of, financial planning; and

- increased competitiveness.

Case study

To illustrate the holistic approach to risk management, it is worthwhile considering the following example:


Company x is a producer of the three major platinum group metals (PGM). Its cost base is made up of diesel and steel. The three metals produced contribute equally to total revenue, while it is assumed that five tonnes of diesel and two tonnes of steel are used for every 13 ounces of PGM metals produced.

Driver variables

Each of the enumerated risk variables of company x's operating margin are highly variable in price. The steel price, for example, has doubled since last year, while rhodium's has more than halved over the same period (see figure 1). As a measure of risk, the realised volatility is provided in table A. Clearly, rhodium has shown itself to be the riskiest of all the variables, steel the least so. As expected, the revenue drivers are closely correlated; cost and revenue show a correlation of around 0.46, which could be interpreted as an indication of the strength of the natural hedge present in the company's business model.

Risk profile and appetite

A reductionist view of the company's market risk profile would focus on the component variables' risk. Such a view would see risk appetite, for example, defined in terms of platinum price risk, ignoring the significant correlation between the drivers. Platinum's variability has realised round 24% historically, yet combining the revenue drivers in risk results in a net volatility of closer to 28%. Furthermore, it has been established that cost and revenue have displayed a significant sympathy in behaviour. The implication of this is quite serious. Fixing revenue via hedging structures could see a significant reduction of margins in the event that metals prices and, by association, costs rally.

A holistic risk view is based on the significant correlations existing between the revenue drivers as well as the cost and revenue bases. Combining risk measures for all the margin drivers results in a net risk profile as shown in figure 2. Margin volatility has been calculated at 31%, clearly much higher than the 24% applying to platinum only. Leaving risk completely open would see stakeholders in the company assume the risk of margins realising below 10% with probability of 62% (see figure 3). If risk appetite is defined in terms of such a 10% lower margin threshold, then clearly actual exposure and risk appetite are dichotomous.

Suggestions on risk management

In the event that future margin is partially fixed upfront by entering into a derivative structure, the variability of margin realisation can be greatly reduced. As an illustration, should company x enter into a swap structure that guarantees half of future revenue and, at the same time, fixes the same portion of the cost base by entering into fixed price forward purchase agreements on steel and diesel, the probability of margins realising below the earlier stated 10% is consequently reduced from 62% to 37%. The fixing of both revenue and cost not only reduces variability, but protects the company against the significant cost-revenue correlation.


The business of business is calculated risk taking. As such, constant awareness of stakeholder risk appetite and actual risk exposure is essential. Furthermore, an active risk management policy that aims at the synchronisation of risk appetite and exposure could result in substantial benefits to a business.

Raveen Ramlakan, Co-head fixed income, currency and commodities

T. +27 11 269 9150


Ettienne van Wyk, Carbon, fuels and metals trading

T. +27 11 269 9995


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