The Changing Role of Hedging in Sourcing

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A few years ago, the number of Sourcing organizations that had a serious focus on hedging to deal with risk were few and far between. Outside of some specific  industries with a traditional dependence on commodities, few CPO’s were actively sponsoring the development of sophisticated financial risk management teams within their portfolio of responsibilities. A recent paper by Blaine Finley and Justin Petit published in the Journal of Applied Corporate Finance (1) does an excellent job of explaining how and why this traditional reticence within most Sourcing teams to engage in hedging is changing.

As the authors note:

Increased pressure for growth and profitability has also led companies with large commodities exposures—both those that are naturally long and those with a natural short—to explore a larger, more strategic role for commodity hedging and trading, as well as the use of innovative risk-shifting mechanisms on inbound and outbound material flows. For many companies, this means drawing on, and coordinating, the expertise and capabilities of four different corporate organizations: Purchasing, Treasury, Selling, and Marketing.

The authors go on to present a sound analysis of the forces driving this evolution (increased volatility and factor costs, for example) and they present a five-part “strategic risk management framework” that, if standard, is nonetheless a solid starting point Sourcing teams starting to think about this topic.

One of the most interesting points the authors make is one I often note to clients as well, and that is the role that self-insurance (often thought of as “free”) plays in managing operational risk. As they note:

Swaps and forwards tend to be the most popular instruments for hedging currency, commodities and interest rate exposures, largely because they do not carry an explicit fee. Surprisingly, it is still difficult today for managers to get approval to spend money to buy “insurance.” However, “free” insurance does not garner the same level of scrutiny, or require the same levels of approval (this is a common flaw in the design of enterprise operating models). 

Of course, all risk has a cost and therefore there is no “free” insurance, even if some people think of it this way. Indeed, one of the most important impacts of starting a formal hedging/risk management process in Sourcing is that, if done correctly, it should illuminate external risk transfer cost vis-a-vis internal “self-insurance.” It is my experience that most self-insurance strategies in supply chain are plagued by a lack of flexibility (i.e., their “coverage” is narrow relative to possible risk spectra) and they are inefficient (i.e., they cost too much).

As I have written often, in the new few years we will see the continued amplification of the phenomenon that Finley and Petit outline in their paper. Indeed, it is notable to find a paper on Sourcing (as core of a supply chain function as there is) in a journal focused on corporate finance. But this paper is one of many to come, and it is a fine start for anyone wanting to start thinking seriously about the appropriate role financial risk management should play in Sourcing.

(1) Finley, B. and Petit, J. (2011). “Creating Value at the Intersection of Sourcing, Hedging and Trading.” Journal of Applied Corporate Finance, 23 (4), 83-90.

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