Setting the hedging straight

I read the “Hedging paper bets” article in the December issue (page 10) with great interest. The author demonstrates how many companies are using financial management tools to transfer paper price volatility to a risk management company. As a result, they are enjoying reduced margin sensitivity, increased cash flow certainty, and a more dependable approach to meeting budget and earnings expectations.

The author, however, fails to explain the mechanics of these transactions accurately. I would like to clarify one statement in particular: “Enron, which adds 15 basis points, or .15%, to the market price, is also hedging its bets, of course, by striking similar (but lower) fixed-price arrangements with paper suppliers – some of which may be the vendors used by their catalog clients.” Unfortunately, this is an oversimplification of how commodity markets work. The price and terms of a paper price contract are based on market conditions and the needs of paper buyers and sellers, both of which are functions of supply and demand within this financial market. As in most competitive commodity markets, price is not based on a simple index-plus formula as claimed by the author.

Enron, a risk intermediary for many commodity products, prides itself in its ability to provide customers with flexible financial options. Catalogers can customize the quantity and settlement terms within their contracts. Once an agreement is reached, Enron uses its risk management expertise to manage all the associated market risks it assumes from the client. We break each agreement into component pieces of market risk, which are then parceled to different books, where they are managed at an aggregate level. Again, our pricing is not a function of an index-plus formula, but rather a result of market supply and demand.

For the benefit of your readers, I would also like to take this opportunity to properly explain the mechanics of a swap agreement. A swap is a financial contract in which a cataloger and a risk management firm agree to exchange, or “swap,” specific price risk exposures over a predetermined period of time. The goal for the cataloger is to lock in the cost of buying paper at a reasonable level.

Here’s an example: Let’s say Cataloger A determines that $900 per ton is a reasonable paper price over the next five years. The company then enters into a five-year swap transaction with a risk management firm that fixes the cataloger’s cost of paper at $900 per ton. Over the next five years Cataloger A will continue to buy paper from its regular suppliers at market prices, just as it has in the past. As the market price for paper rises above $900 per ton, the risk management firm pays Cataloger A the difference between the market price and the $900 fixed price, offsetting the increase. Conversely, as the market falls below the $900 fixed price, Cataloger A will pay the risk management firm the difference, offsetting the decrease. The net result: Cataloger A is provided with a stable paper price of $900 per ton.