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Hedging With Financial Instruments
- Workshop -
Paper Recycling
Conference & Trade Show
New Orleans
June 23, 2002.
Gary Helik
Tradition Financial Services
ghelik@tfsbrokers.com
TOPICS
Why Hedge?
Some Hedging Basics
Market Pricing
Forward Price Behavior for Recovered
Fiber
Hedging Examples for Recovered Fiber
Hedging RCP in an Open Market
Change + Pain = Gain
Q+A
2
Why Hedge?
Why Hedge?
Hedging is RISKY
Look at Enron!
Why sell forward for less than I can get
now?
Hard to follow „financial‟ compared to my
„physical‟
4
Why Hedge: Services
COMMODITY PRICE HEDGING = CUSTOMER RETENTION AND GROWTH
5
Why Hedge: Producer
COMMODITY PRICE HEDGING = AVOIDING PRICE RISK
6
Price: Main Profit Driver for Paper Producer
Impact of +/- 10% factor change on ROCE
7
Hedging Case Study: Finance Thesis
Using Forward “Contracts”
Background
subject: M-Real paper business
finance thesis - Helsinki School of Economics, Finland
measured effect of 1 to 3 yr financial contracts (swaps)
• 20,000 price simulations
8
Hedging in Paper Manufacturing:
Finance Thesis
“Floating” = Landlord w/o Leases
LOSSES Mean 719 Euros
St. Dev 510 Euros
Skewness 29%
9
Hedging in Paper Manufacturing:
Finance Thesis
Using “50% Forward Contracts”
Mean 729 Euros
LOSSES
St. Dev 434 Euros
Skewness 27%
10
Hedging in Paper Manufacturing:
Finance Thesis
Using “85% Forward Contracts”
Mean 746 Euros
St. Dev 354 Euros
LOSSES
Skewness 18.4%
11
Forecasts Give Poor Price Signals
Oct 2000 Dec 2000 May 2001 Jan 2002
Forecasts: Wall St Bank
Futures: Pulpex
Actual: RISI US
12
Forecasts Give Poor Price Signals
RISI Newsprint Price Forecasts –– Q1 2000 to Q1 2002
July 2000 Jan 2001 July 2001 Jan 2002
Jan 2000
“Irrational
Exuberance”
Actual
Forecasts: US based private
Forecasting
Service Bad price signals = bad business decisions
13
Hedging: Supply Chain Effects
COMMODITY PRICE HEDGING = PRICE PREDICTABILITY IN THE
CUSTOMER SUPPLY CHAIN
HEDGE
PACKAGING PRICE
HEDGE PROVIDE PREDICTABLE
RCP PRICE END PRODUCT PRICE
EARNINGS 14
PREDICTABILITY
Some Hedging Basics
Defining Price
Spot Contract Forward
per good for > 1 month,
transaction - month, or until extended
daily (or “further duration
intraday) notice” physical or
• no discounts • less financial
• specific discounts
transaction • monthly
volume volume, tied
• whse pickup to annual
in days volume
physical or
financial
16
Types of Forward Agreements
Physical Agreement Financial Agreement
Pros Pros
• no intermediaries • ISDA contract
• direct, easy • fungability
• low cost • more counterparties
Cons Cons
• contract • new to RCP
enforceabilty = uncertainty
• setting price level • change: people,
• nonfungability skills, technology
FUNGIBLE: “freely exchangeable for or replaceable
by another of like nature or kind in the satisfaction
of an obligation” 17
Hedging Price --> A MANAGEMENT TOOL
• What is Price Hedging?
- Using financial structures to replace unknown future prices
with known future prices
- Re-engineering transaction cash flows to a desired profile
- Revenue (or cost) line becomes predictable
- Fungible --> transactions can be reversed by taking opposite side
• Cash-settled financial instruments based on fully enforceable ISDA
contracts locking in price and volume terms against an index
- focuses management to exert control over price and operations
- allows creative pricing solutions
18
Components of a Financial Price Hedge
ISDA documents --> legal framework for OTC swaps
- standardized, fully enforceable, global contract
- Pulp & Paper, currency, interest rates, energy, metals, etc.
Price index --> to settle the contract
- independent & objective public record of price
OCC #11
50,000 TPY
3 Years Transaction specifics
$70/Ton(2)
July 1, 2002 start
(1) International Swap and Derivatives Association
(2) Prices and volumes are for illustrative purposes only.
19
Financial Swap --> A Fixed Price Arrangement
Buyer receives
cash
from Seller
relative to Index Price
Agreed Fixed
Price
Seller receives
cash
Spot Price from Buyer
Index relative to Index
Price
Time
20
Example Swap Transaction
--> Matching Financial Hedge to Physical Business
OCC Buyer purchases 1000 t/m of physical OCC on a floating price basis.
Separately she buys a financial swap to lock-in a fixed $50/t price for the OCC
for a 6 month period, 1000 tons/ month, indexed to OBM .
FINANCIAL PHYSICAL
Cash NET PRICE -
6 Mo OBM Index Flow offset
OCC Swap Price from physical to
USD/TON Price (Hypothetical) Swap Buying Price financial HEDGED:
SMALL
Sep 50 40 -10 40 50 PRICE
Oct 50 42 -8 42 50 MOVEMENTS
Nov 50 44 -6 44 50
Dec 50 48 -2 48 50
Jan 50 55 5 55 50
Feb 50 60 10 60 50
Mar 50 63 13 63 50
AVERAGE 50 50 0 50 50
UNHEDGED:
HIGH VALUE 50 63 13 63 50 LARGE
LOW VALUE 50 40 -10 40 50 PRICE
MOVEMENTS
RANGE 0 23 23 23 0
Hedging neutralizes effect of spot price movements 21
Hedging: When is the Right Time?
Price
Level
ZONE OF MISSED OPPORTUNITY
800
I want to sell at the high”
750
Sellers abundant but
700 buyers disappearing
as price becomes
prohibitive for
650 ZONE OF intended use
PRICE
600
ENGINEERING
Buy into Weakness Sell into Strength
550
500
Buyers abundant but
sellers disappearing
450
as price level becomes ZONE OF MISSED OPPORTUNITY
unfavorable vs I want to buy at the low”
400
production economics
Time Bulls Make Money,
Bears Make Money,
Pigs Get Slaughtered 22
Price Cap --> Protecting Against Higher Prices.
The cap buyer (ie. food company) pays an up-front per-ton premium (fee) to the
seller (ie. Liner producer). If the spot price exceeds the strike price, the
cap buyer is compensated. Otherwise, no compensation is required .
Index or Cap Buyer receives
Spot Price compensation from
Cap Seller
Cap Strike Price
No compensation
required
Time
23
Price Floor --> Protecting Against Lower Prices
The floor buyer (ie. RCP generator) pays an up-front per-ton premium (fee)
to the floor seller (ie. Liner mill). If the spot price falls below the floor strike price, the
floor buyer is compensated by the floor seller. Otherwise, no compensation is required.
Index or
Spot Price No compensation
required
Floor Strike
Price
Floor Buyer receives
compensation from
Floor Seller
Time
24
Price Collar--> Combined Cap and Floor
Index or
Spot Price Cap buyer receives
compensation
Cap Strike Price
No compensation
required
Floor buyer receives
compensation
Floor Strike Price
Time
A collar protects against adverse price movements, at a cost of giving up favorable
price movements. The cap buyer is compensated above the cap strike price while
the floor buyer is compensated below the floor strike price. The strike price of the
cap and floor can be structured so that the transaction has zero premium cost.
25
Physical & Financial Coexist, but are Separate
PHYSICAL FINANCIAL
Product Settlement Cash Settlement
Spot price
Discounts Price --> FIXED
Volume for any time period
Specifications Volume
Delivery
Technical Support
Risk Exposures Risk Exposures
• price • counterparty credit
• volume • index tracking
• quality • internal controls
• logistics
26
„Market‟ Pricing
„One Way‟ Market Pricing
Pulp & Paper
Traditional Buyers have key
Pricing market info
Duration 30 DAYS see real offers
able to compare with
Seller other buyers
Seller Sellers don‟t always
have exact
Buyer Seller benchmarks
illegal to discuss
offers w/competitors
Seller clearing level
depends on
Seller anecdotal info
28
„Open‟ Market Pricing
SPOT +
FORWARD
PRICES Open Markets
buyer seller regulators & industry
BID | OFFER
analysts support
buyer seller transparency
Spot /
OTC / buyers, sellers,
buyer seller investors have equal
Futures
buyer seller access to price
Market
neutral transaction
buyer seller clearing
forward prices work
Used by Metals, Energy, like „live‟ forecasts
Currencies, Bonds, Stocks…..
29
Open Market Example: Fx Options
(Volbroker)
TFS
Volbroker
Partner
Banks
- CitiGroup
- Deutsche Bank
- Goldman Sachs
- JP Morgan
Chase
- Royal Bank of
Scotland
- UBS Warburg
30
Open Market Example: Pulp and Paper
31
Forward Price Behavior -
Recovered Fiber
Swap Prices: OCC
33
Swap Prices: ONP
34
Hedging Examples
Recovered Fiber
RCP Price Exposure
PRODUCT FLOW
GENERATORS
BROKERS
• RETAIL PAPER MILLS
• INDUSTRIAL
• MUNICIPAL PACKERS
PRICE EXPOSURE HIGH MED HIGH HIGH
BUSINESS SENSITIVITY MED HIGH HIGH HIGH
HEDGING NECESSITY HIGH MED HIGH HIGH
36
Transaction Structures: Packer
PRODUCT FLOW
GENERATORS
• RETAIL PAPER MILL
• INDUSTRIAL
• MUNICIPAL PACKER
Packer bidding on 1 yr contract OCC from retail
generator - 1000 t/m
What contract possibilities exist?
#1) Physical: bid fixed, sell floating
Financial: sell fixed swap
• lock in spread via financial hedge
#2) Physical: bid fixed physical with some upside
participation to generator
Financial: buy price cap for upside participation
sell fixed financial to lock in spread 37
OCC Hedging Scenarios
CASES 1 & 2
12 & 18 Month
Hedges CASE 2
12 Month
Hedge CASE 3
12 Month
Hedge
38
2000: 12 & 18 Month Hedges, July Start
CASE #1 CASE #2
39
2001: 12 Month Hedge, Jan & July Starts
CASE #3 CASE #4
40
Hedge Summary
41
Hedging RCP in an Open Market
Transition To Open Market –
Individual Customer Supply Agreements
Buyer / Seller negotiate price / volume annually (or less often);
outcome of price discussion is a premium or discount level relative to
floating market clearing price
CUSTOMER INDIVIDUAL
CUSTOMER
Premium CONTRACT NEGOTIATION AGREEMENTS
to Market
+ % Customer A PRICE
+ % Customer B FLOATS
AT
FLOATING OPEN MARKET PRICE OPEN
- % Customer C MARKET
- % Customer D
Discount
to Market
43
Open Market Transaction Flow
INITIAL FIRM’S FINAL
POSITION OBJECTIVE POSTION
BUYER BUYER
HEDGES BOUGHT
50% 50% FOR 1 YR;
FOR 1 YR 50% FLOATS
BUYER BID | OFFER
OPEN MARKET
FLOATING TRANSACTION HEDGES OFFSET
POSITION FLOATING EXPOSURE
SELLER
HEDGES
SELLER 25% SELLER
FOR 1 YR SOLD
25% FOR 1 YR;
75% FLOATS
AVERAGE DAILY
OPEN MARKET
TRANSACTION
PRICE
SELLER INVOICES BUYER FOR
TOTAL MONTHLY VOLUME
AVERAGE MONTHLY
@ AVERAGE OPEN MARKET
OPEN MARKET
MONTHLY PRICE W/ADJUSTMENTS
TRANSACTION
PER INDIVIDUAL AGREEMENT
PRICE
44
Separating Price From Supply
Sellers can Buyers can
achieve achieve
• No monthly Seller Buyer • No monthly
haggling, haggling
renegotiations
• Long term
• Focus on added agreements
Open
values, long term
Market • Product focused
relationship
on service and
Price
quality
• Use open market
to separately
manage price
45
Change + Pain = Gain
Creating Shareholder Value Requires
Breaking Down Barriers Between Silos
REVENUE -- COST = SHAREHOLDER
VALUE
SALES MERCHANT PRODUCTION
GROUP GROUP GROUP
• volume contracted • fiber
• price forwards • labor
• energy
• capacity
utilisation 47
Why Hedge?
Give customers price choices beyond „spot‟
Business Predictability
Manage timing of price moves
• revenue/cost control --> margin control
Financial Engineering
• financial leverage
• credit enhancement
• equity valuation
48
Why Hedge ? …. Earnings Consistency +
Knowledge of Forward Market Conditions
FLOATING
Financial
predictability
+ consistent
operations
• capex
• R&D
CONTRACTED
• people
FORWARD --> 1 YEAR
+ customer
choices
2 YEARS + market
3 YEARS signals
+ share value
4 YEARS - debt cost
capital structure
5 YEARS
49
Buyers and Sellers Can‟t Change Markets,
But Must Know How To Respond Appropriately
Managing a profit process shouldn‟t be left to
chance when it comes to price
Do forecasts provide proper market direction?
Is a short (30 day) price window sufficient to
manage long term business goals?
Has a floating price been a successful way to
create shareholder value?
Can transacting in open markets with forward
prices practices ensure more profit certainty ?
Bad price signals = bad business decisions
50
Thank You ……..Q & A
TFS-ICAP top broker TFS-ICAP top broker
Currency Options Categories: Exotic Options Categories
USD / Euro USD / Euro Barriers
USD / Japanese Yen USD / Japanese Yen Barrier
USD / Swiss Franc USD / Sterling Barrier
USD / Canadian Dollar Other Barriers
USD / Australian Dollar Binary / Digital
USD / Norwegian Krone Hybrids / Trigger
Euro / Sterling Volatility / Variance Swaps
Euro / Japanese Yen Average Rate Options
2001 Risk Rankings:
Source Risk Magazine September 2001 Long-dated Options
TFS - most combined 1 st and 2nd place positions in energy markets
• oil, electricity, electricity options and weather
U.S., London, Frankfurt, Singapore
2002 EPRM Rankings
Source EPRM Magazine February 2002
51
