RISK MANAGEMENT

The Forgotten Ones Specific Commodity Hedgers

by Franois Masquelier, Head of Corporate Finance and Treasury, RTL Group
In brief
So far, the IASB has forgotten some commodity hedgers. The hedge accounting for commodity works when underlying are listed or when futures exist on regulated markets. The use of ratio or differential techniques, although classical, often does not qualify for hedge accounting. What can we expect on the commodity side?

he preparers involved in commodity hedging have several times tried to address a specific issue to the IASB without any success so far, although it is a real issue for many companies which want to hedge specific commodity purchases. Usually commodities quoted on dedicated markets like Chicago are by definition of common quality and rather standard. But some companies look for protection of purchases of commodities, which are not necessarily listed as futures or which are not basic in quality. For example, when a coffee manufacturer wants to hedge its Columbian coffee needs when Arabica hedging exists, what can he do? When an air freight company wants to hedge jet fuel purchases, what can it do apart from buying crude oil hedge instruments?

Differential technique
To obtain the desired quality of commodity, a company would pay a differential (also called ratio) to obtain the required quality or type of commodity. Differentials and ratios are not derivatives instruments but are execution contracts, although they only try to compensate the potential price difference between basic quality quoted and specific quality targeted. There are correlations between underlying commodities but not necessarily always close ones. Accounting wise, the problem comes from IAS 39 82 stating that when the hedged item is a non-financial asset or non-financial liability,
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it shall be designated as a hedged item (a) for foreign currency risks, or (b) in its entirety for all risks, because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fair value changes attributable to specific risks other than foreign currency risks. In the previous version of IAS 39, a company could take the differentials and futures when determining effectiveness of commodity hedges. Depending on the price, the differential may render the hedge ineffective and inefficient as defined in IAS 39. The future hedge should be considered as partial hedge of the specific commodity requested. The difficulty of isolating and measuring fair value changes attributable to specific risks should not be a reason for preventing hedging of specific commodity risks. The ratio and differential techniques used for cocoa, coffee and other

defined commodities are well known on the market and usually used by companies to hedge commodity risks. Futures only cover average quality and not specific ones. It corresponds to usual and best practice risk management policies long applied by corporates. These differentials were invented centuries ago for offering such protection to purchasers of commodities. The need is for a partial hedge of a final commodity. It is possible for credit risks and not for commodity risks. The spread is also a differential, which can vary independently from the underlying interest rate.

Solutions? Not really

The regression analysis models are potential solutions. But these models are very complicated to run and require sophisticated IT tools. Provided it is highly correlated and the best known hedging strategy or product

Usually commodities quoted on dedicated markets like Chicago are by definition of common quality and rather standard.

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available on the market, it should be tolerated. The differential should really be considered as a credit spread and should be excluded in the effectiveness testing and calculation. Weather elements, political conflicts, etc. could affect pricing of some products in certain areas and not in others, creating a certain de-correlation.

Removal of effectiveness corridor

The Working Group on Financial Instruments (WGFI) has addressed the idea of removing completely the band of 80 to 125% for the effectiveness testing. By excluding the effectiveness corridor to be respected at inception and throughout the life of the hedging instrument, IASB could indirectly give support to commodity hedgers when hedging non listed raw materials. At least when non efficient as defined by IAS 39, the whole hedging will not be ineffective but only a portion of it. The solution is certainly unsatisfactory for commodity hedgers. But we have experienced with IASB situations where half a solution is better than no solution at all. It does not prevent us from continuing to lobby in favour of these specific hedgers.

As always with the IASB, no one can predict its reaction. The recent easing of its position on intragroup cashflow forecast hedge accounting opens doors to further necessary and logical amendments. When EACT Board members met the new European Commissioner Charlie McCreevy, they reiterated EACTs recommendation to adapt sound accounting rules matching best practices in terms of risk management. The position of the Commissioner, clearly stated in newspapers, proves that he does not intend to accept everything issued by the IASB. He promised EACT to keep requiring changes in IAS 39 where necessary. He was very sympathetic towards the positions defended by our Association. He understood that treasurers act to eliminate P&L volatility as far as possible.

Putting the cart before the horses

An accounting rule should never prevent companies to keep using proved risk management techniques, used for decades. If so, it means financial decisions are sometimes driven by accounting rules. The IASB has often assumed, too easily, that in general risk management techniques used by preparers are speculative. If accounting is a science, as E.B. Titchner said, we might sometimes think that common sense is its very antithesis.

RTL Group
With 31 television and 30 radio stations in 10 countries, RTL Group is Europes largest TV, radio and production company. The Luxembourg-based media group operates TV channels and radio stations in Germany, France, Belgium, the Netherlands, UK, Luxembourg, Spain, Portugal, Hungary and Croatia. It is one of the worlds leading producers of television content such as game shows and soaps, including Pop Idol, Good Times, Bad Times, Family Feud and The Bill. RTL Group was created in Spring 2000 following the merger of CLT-UFA, the TV and radio group owned by Bertelsmann AG (with the German newspaper group WAZ) and the Belgian-Canadian Groupe Bruxelles Lambert (GBL), with the British production company Pearson TV owned by the UK-based media group Pearson plc. In July 2001, Bertelsmann became majority shareholder of RTL Group following a stock swap with GBL in which GBL changed its 30 % stake in RTL Group against a 25 % stake in Bertelsmann AG. In December 2001, Bertelsmann entered into an agreement with Pearson plc to acquire its 22 % stake in RTL Group, raising Bertelsmanns interest in RTL Group to 90.4%. The remaining 9.6 % of RTL Group are publicly traded.

EACT lobbying
EACT, as for tender portfolios hedging, tries to defend its members position each time it detects potential issues and practical problems while applying classical risk management strategies.

Franois Masquelier
Honorary Chairman, Head of Corporate Finance and Treasury, RTL Group
Franois Masquelier has been Head of Corporate Finance and Treasury with RTL Group since November 1997. Before joining RTL Group he worked for Mitsui Talyo Kobe Bank (Sakura Bank) in Brussels, Eridania Bghin-Say Coordination Center in Brussels and ABN AMRO Bank in Belgium and Luxembourg. He is Doctor in Law, Fiscal Law and Economy & Administration from the University of Lige, and has a degree from the Business School of Brussels. Franois is the President of the Association of Corporate Treasurers in Luxembourg (ATEL), and the Honorary Chairman of the European Associations of Corporate Treasurers (EACT).

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