Don’t Hedge Lightly

Citic Pacific recently announced it faced a near $2 billion loss on a contract thanks to trading write-downs due to its "currency exposure to an iron ore mining project in Western Australia, for which supplies were obtained using Australian dollars and euros." The problem -- as Southwest recently found out in a surprising quarterly loss thanks to underwater hedges is that some contracts "do not qualify for hedge accounting … and must be marked to market at the end of each financial period." Citic's hedging cock-up should serve as a lesson to all companies that consider taking commodity price exposure off the table that not all commodity price mitigation strategies are created equal. It's also a reminder that GAAP and related treatment of hedged contracts can negatively impact earnings performance in the near-term.

Given these accounting standards, options contracts -- as opposed to futures -- where I'm guessing the only accounting hit would be for the risk premium which is factored into the cost of the contract price, might be a better bet because with options there is no requirement to take delivery. But before running out and investing in options -- where they're available, which is not everywhere -- organizations should seek specific advice from trading and accounting experts in the area under consideration.

- Jason Busch

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