Hedging is an important strategy for companies effected by the volatility of the commodity markets, enabling them to stabilize costs and protect profit margins. While the benefits of hedging are well-recognized, the associated costs and setups are often hidden beneath the surface. Understanding these hidden expenses and structures is essential for making decisions and ensuring that hedging enhance financial stability, rather than deteriorating it. This chapter explores the various costs of hedging, before dealing with hedging dynamics and “zero-margin-zero-fees” account setup risks, in the following articles.
Minimum Margin Requirements and Financing Costs
Minimum Margin Requirements
Brokers and banks require companies to keep a minimum amount of money in their brokerage accounts, no matter how big or small their hedging position is. For example, a major bank might ask for $10 million to be held in the account, to just open a Prime Brokerage account, even if the company isn’t making any trades. On the other hand, major brokers may only require $1 million to open an account.
Margin Calls and Additional Risks
If the hedging position goes against the company, they will receive a margin call. This means the company must add more money to the account to cover the losses and return the margin to the minimum required level. Most companies don’t keep extra cash on hand and have to use expensive credit lines quickly to meet these demands. Even though the loss from the hedge is usually temporary - since it’s meant to protect the company’s physical exposure that is gaining value - the negative cash flow from the hedge must be handled immediately. In contrast, the positive cash flow from the main business comes later. This risk can create an urgent need for cash, strain a company’s finances, and raise costs. This is the main reason many SMEs avoid hedging altogether.
Case Study: ExtraFreshFoods Inc.
ExtraFreshFoods Inc. is a food manufacturer with an annual revenue of $30 million and an EBITDA of $1.6 million. To protect against rising commodity prices, ExtraFreshFoods decides to hedge using futures contracts.
Minimum Margin Requirements
If ExtraFreshFoods uses a major bank, they must place a minimum margin of $10 million in their brokerage account. Alternatively, a broker requires only $1 million to open an account. For ExtraFreshFoods, tying up $1 million at a 10% interest rate costs $100,000 each year, which is a significant expense compared to their EBITDA.
Financing Costs
Borrowing $1 million at 10% interest costs ExtraFreshFoods $100,000 annually. With an EBITDA of $1.6 million, this interest expense represents a large portion of their earnings, making such margin requirements financially burdensome.
Margin Calls and Additional Risks
If the hedging position moves against ExtraFreshFoods, they will receive a margin call to cover the losses and restore the required margin. Most companies like ExtraFreshFoods do not keep extra cash and must use expensive credit lines quickly. This sudden need for funds is a major disruption to cash flow and operations.
Impact on Financial Health
For ExtraFreshFoods, keeping large margins and covering margin calls consumes capital and threatens their cash flow and financial stability. As a result, they don’t hedge. The high costs of traditional hedging approaches make them a poor fit for smaller companies.
Account Maintenance and Direct Execution Costs
Account Maintenance
Maintaining a broker account comes with ongoing costs beyond the initial margin requirements. Both banks and brokers typically charge minimum activity fees, regardless of how much or how little one to trade. For example, major banks may require minimum annual fees of $2 million or more just to keep the account active. These fees cover account setup, administration, and support services. The amount can vary widely depending on the broker and the level of service provided, significantly adding to the overall cost of hedging.
Direct Execution
This is the most known, and commonly negotiated - at times up to a point of being "waived"- cost of hedging. Each trade executed through a broker involves commissions and fees that vary based on trading volume and may include minimum fees per trade. A portion of these fees is paid to the exchange, while the remainder serves as income for the broker.
Trading Platform
Effective hedging requires advanced trading platforms that provide real-time data, analytics, and execution capabilities, which come with varying subscription fees based on features and access levels. Additionally, companies must invest in IT infrastructure, including licenses, systems, and their maintenance, to support the trading operations.
External Advisors
Many companies rely on external advisors or consultants to develop and manage their hedging strategies, benefiting from their professional expertise and deep domain knowledge. These advisors play a crucial role in enhancing the effectiveness of hedging activities through their specialized insights. However, their services come with costs such as retainer fees, hourly rates, or performance-based compensation. Additionally, advisors may have financial ties to banks, brokers, and other ecosystem stakeholders, which can create conflicts of interest and influence their recommendations.
Operational and Administrative
Hedging involves daily risk management and bookkeeping, requiring the finance team to have domain expertise and time to manage the financial operations. This increases the overall overhead of the finance department allocated directly to the hedging activity.
Conclusion
The most unknown cost of hedging is the cost of money for margins, along with the burden of initial margin requirements and the risk of sudden margin calls needing quick extra funds. These can severely impact a company’s financial health. To mitigate these high expenses, some institutions offer zero-margin accounts, among other “creative” setups. However, these arrangements often come with significant hidden risks.
In the next section, we will look at the financial infrastructure and mechanics of hedging. In the third part, we will highlight the risks and implications of zero-margin setups. Understanding these elements is essential for companies to implement effective and secure hedging strategies without compromising their financial stability.
Disclaimer
The information provided in this article is for general informational purposes only and should not be considered financial advice. It is not intended to offer any financial advise, recommendations or endorsements. I am not responsible for the accuracy or completeness of any information provided. Any decisions made based on the content are the sole responsibility of the reader. Always consult with a qualified financial professional before making any financial decisions.
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