Hedging Strategy Analysis for Sims Metal Management Essay

Sims Metal Management (SGM) is a global Australian-based company that specializes in metal recycling, operates business in North America, Australiasia( Australia and Asia) and Europe, with North America being the largest market. The company’s activities expose it to the three major parts as financial risks: market risk, credit risk and liquidity risk. Market risks consist of interest rate risk, foreign exchange risk and commodity price risk. Firstly, SGM’s main exposure to interest rate risk is its borrowings at variable interest rates.

As a result, the value of their financial instrument or cash flows will fluctuate. This risk constantly exists and is of significant importance to the company’s cash flows. Secondly, SGM operates internationally, so it is exposed to foreign exchange risk, primarily with respect to transactions settled in US dollars. Foreign exchange risk arises when future commercial transactions and recognised assets and liabilities are denominated in a currency that is not the entity’s functional currency. Lastly, SGM is also exposed to risks of market price fluctuations.

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While SMG strategically focuses on recycling, more than 70% of its revenue comes from producing recycled ferrous and non-ferrous metals. The fluctuation of the price of both the raw materials and the recycled metals will affect the group’s revenue and cash flow directly (SMM annual report, 2011). On the other hand, credit risk and liquidity risk are also challenges that SGM faces. As for credit risk, which refers to the case where the counterparty will not complete its obligations under a financial instrument and cause a financial loss to the company.

So far, SGM has exposure to credit risk on all financial assets and transactions in derivative contracts. Liquidity risk also arises when SGM has insufficient access to capital to fund growth projects or settle a transaction on the due date. As a result, the company would be forced to sell financial assets at a value which is less than what they are worth or refinance the Group’s borrowing facilities (SMM annual report, 2011). Figure 1 show the risks faced by SMM briefly. Risk Management of Sims Metal Management

The overall financial risk management strategy of SGM seeks to mitigate risks to minimize potential adverse effects on the financial performance. Risk management is carried out by a limited number of employees as authorised by the Board. In this report, we focus on the derivative and non-derivative financial instruments that used by the company. Firstly, we elaborate how SGM hedges its exposure to currency fluctuations in foreign exchange rates and commodity prices with derivative financial instruments.

Then we briefly show how they deal with interest risk, credit risk and liquidity risk using methods other than derivatives. In terms of foreign exchange risk management, to protect against exchange rate movements in relation to material purchases and sales and underlying transactions between subsidiaries, SGM enters into forward foreign exchange contracts to buy and sell specific amounts of various foreign currencies in the future at predetermined exchange rates. The forward foreign exchange contracts are used to hedge transactions denominated in currencies which are not the functional currency of the relevant entity.

These contracts are hedging highly probable forecasted transactions for the ensuing financial year. The contracts are timed to mature when monies from the forecasted sales are scheduled to be received or when payments for purchases are scheduled to be made. On a limited basis, the company also utilizes option contracts to hedge its foreign currency exposure (SMM annual report, 2011). In terms of commodity price risk management, SGM enters into forward commodity contracts matched to purchases or sales of metal and precious metal commitments.

These contracts protect against movements in the underlying commodity of the related material purchase or sale. The company’s primary exposure is to copper and nickel prices, so its commodity contracts consisted primarily of copper and nickel contracts. At the end of the reporting period (2011), none of the Group’s forward commodity contracts qualified for hedge accounting, despite being valid economic hedges of the relevant risk(SMM annual report, 2011). . When it comes to interest rate, credit risk and liquidity risk management, SGM has not used any derivative financial instruments.

More precisely, interest rate risk is managed on the company’s net debt portfolio by providing access to diverse sources of funding, reducing risks of refinancing by establishing and managing in accordance with target maturity profiles, and negotiating interest rates with banks based on a variable pricing matrix which generally involves a LIBOR rate plus a margin. As for credit risk, SGM has set up credit limits for its customers. For certain customers, SGM purchases credit insurance to protect it against collection risks.

Lastly, the company manages liquidity risk by monitoring forecast and actual cash flows and matching the maturity profiles of financial assets and liabilities (SMM annual report, 2011). Figure 2 shows SGM’s risk management briefly. Recommendation of Hedging Strategies SGM is a company domiciled in Australia, but operates business internationally. Therefore, currency fluctuation in foreign exchange rates is a prominent challenge the company faces. SGM adopts a “local revenue, local cost and local financing” approach, which means each of the company’s entities uses the currency of the primary economic environment in which the entity operates.

However, SGM still have to tackle the risk of foreign exchange rate as the company has to convert AUD to the foreign currency of the country where they operate, to fund their operations. Moreover, although the revenues of SGM consist primarily of foreign currency, most of the dividends are paid in AUD. So far, SGM primarily hedges its cash flow against fluctuation in foreign exchange rate by forward contracts, and by option contracts on a limited basis. We suggest that the company increase the use of option contracts over forward contracts for two reasons.

Firstly, option gives company more flexibility as it gives the company the right to sell (or to buy) the underlying asset, while in forwards there exist “the obligation” to sell (or to buy) the underlying asset. Secondly, option can be used to hedge uncertain future cash flows, and it eliminates downside risk whilst retaining unlimited profit potential. Recently, AUD tends to weaken continuously. Attention is now focusing on the coming board meeting of Reserve Bank on 2 October (The Australian Financial Review, 2012).

In addition, according to Ben Amrany (Australian Dollar Forecast, 2012), AUD will weaken by another 1-2% since there is a around 85% chance that the RBA will cut interest rate in October. (Financial Forecast Center, http://www. forecasts. org/ausd. htm) As Australian dollar is expected to be depreciated in the following periods, we suggest that SGM can use option contracts to hedge its cash flow against the probable depreciation of Australia dollar. For its entities in foreign markets, they receive funds denominated in AUD while operating in local currency.

If the AUD weakens against the local currency, the costs of operating would become higher. Therefore, they can purchase put options on AUD or call options on the local currency, which entitles them to a certain amount of money for local currency sterling at a predetermined rate. By doing this, they protect the value that firms expect or yield a profit if the expected cash is not received but foreign exchange rates move in its favor. On the other hand, for headquarters in Australia, they receive foreign currency and have to convert it into AUD.

As USD contributes to the biggest portion of SGM’s revenue, Figure 3 (Becker & Fabbro, 2006) shows that by using call options, it eliminates the downside risk for revenue if the AUD-USD exchange rate appreciates beyond the option strike, while at the same time preserving any revenue gains that would accrue if the AUD-USD exchange rate depreciates (under which circumstance the holder would choose not to exercise the option, but rather convert receipts into Australian dollars in the spot market at a more favourable price).

Figure 3 shows the revenue under option hedging. Aside from trading a plain vanilla option, SGM can also consider to use a spread trading strategy (Richard Lee, 2011), which involves taking a position in two or more options. Using those trading strategy, company should be confident enough about the trend of foreign exchange rate. Even though we assume that AUD is going to depreciate from many aspects, it will not be a significant depreciation. A more conservative strategy can be implemented on the base of no significant fluctuation of the value of AUD.

Hence, we advise the company to adopt a calendar spread strategy (Hull, 2011), which can be created by selling a call option on AUD with a certain strike exchange rate and buying a longer-maturity call option with the same strike exchange rate. Such a strategy makes profits if the spot exchange rate at the expiration of shot-maturity option is close to the strike exchange rate, the profit pattern from a calendar spread is shown in figure 4. If the exchange rate is very low when the shot-maturity option expires, the short-maturity option is worthless and the value of long-maturity option is close to zero.

The company therefore incurs a loss that is close to the cost of setting up the spread initially. On the other hand, if the spot exchange rate ( assume it is R), is very high when the short-maturity option expires, the short-maturity option cost the company R-X, and the long-maturity option is worth a little more than R-X, where X is the strike rate. Similarly, the company makes a net loss that is close to the cost of setting up the spread initially. If R is close to X, the short maturity option costs the company either a small amount or nothing at all while the long-maturity is still quite valuable.

In this case, a significant net profit is made. Figure4 shows the profit pattern from a calendar spread. To conclude, SGM faces various risks among which the foreign exchange rate risk remains the most significant as it operates internationally. So far, SGM has entered into forward contracts to hedge their cash flow against the currency fluctuations in a foreign exchange rate. In this report, we suggest that SGM should make more use of option contracts as it offers more flexibility to the company with uncertain cash flows.

Furthermore, we propose a calendar spread strategy consisting of two option contracts with the same strike exchange rate but different expiration date, base on the prediction that the USD value will drop but not significantly. However, nothing is guaranteed risk-less. We cannot deny the fact that option contracts come at a higher premium than forwards contract, especially calendar spread. In addition, the prediction of the trend of AUD may not match reality due to various factors, such as the change of interest rate or macroeconomic environment.