At a recent business breakfast held by the Dubai Gold & Commodity Exchange (DGCX) and the Association of Corporate Treasurers (ACT) this question took on significant importance.

Although Non-Financial Corporations (NFCs) rarely look at futures markets as a way of hedging their risk, it soon became clear that maybe not all Treasury departments assess risk in the same way. By risk, we are talking about the income and expenditure that can occur in a currency that is not the base currency for that corporation, or the fluctuation in price of raw materials required by that corporation over a period of time. Essentially, a Treasury department’s primary function is to remove risk, and to do that, they need to trade. That trade can be carried out in two ways; Over-The-Counter (OTC) or using a listed derivative traded on a regulated exchange or futures market.

De-risking, or reducing your corporation’s exposure to risk is called ‘Hedging’. Now this is where the lead question takes on a little more significance. To trade is essentially an active decision, but deciding not to trade could be an equally conscious decision and could also be considered a trade.

Everything we do in life, every decision we make on a daily basis could be considered a ‘Trade’. Each decision has an opportunity cost or benefit to it, which is classified as the profit or loss from that decision.

Earlier on, we briefly touched on the two types of transaction that can be used to cover risk; OTC and Futures. As more and more regulation make its way into the financial markets corporate entities are being pushed to transact on regulated, transparent derivative or futures exchanges where costs are traditionally kept low and trade settlement is guaranteed by a clearing house.

The prices and process on these exchanges are easy to understand and all impact costs can be assessed in advance. The OTC transactions, although used by many are a little more opaque, with rates and fees sometimes harder to identify, with an element of profit needing to be built in for the counterparty. After all, no one works for free.

That said, for many corporations the use of OTC transactions goes hand in hand with other types of lending and helps to utilise credit lines extended from banks. Ironically, when trading or hedging on OTC markets, more often than not, that transaction will end up hedged via derivatives or futures exchange by the counterpart.

After the financial crashes of 2000-01 and 2007-08 various regulatory bodies have created a new set of rules that outline how corporate entities can be classified, and what rules they need to abide by. This does not just pertain to banks or trading companies, but to every corporate entity that works through a regulatory body.

In the USA they have Dodd-Frank, classifying how corporations could be regulated if they traded a certain amount of business. In Europe, all eyes have been on Basel III and Mifid II. All of which are longer and more complex than their previous incarnations, but have been written to protect not just the integrity of the markets, but also those that trade in them, and ultimately the people unaware that they are affected by them, that is every single one of us. These markets can affect the prices of many things influencing our daily lives; mortgages, oil, gold and foreign exchange fixing by banks to name just a few.

We are often told that hedging is expensive and risky by those that don’t hedge. The truth is contrarian as it acts as an insurance policy in an increasingly volatile world. As an example, looking at crude oil, that was trading over $100 (Dh367) a barrel, and then slipping below $30 a barrel, before moving to its current level in the mid $40 range. Saudi Arabia produces approximately 10 million barrels per day. As a rough calculation and using an average of $50 per barrel lost without hedging, this cost the country $500m per day and continues to do so. If you extract that over the course of a possible hedging timeframe of five years the amount totals $1 trillion.

Although Saudi Arabia is a country, it could have hedged just like a corporation can. It could have executed this hedge in a fully transparent cost-effective manner a number of years in advance, thereby insuring themselves against the current climate of lower prices. If this does not highlight the importance of hedging, then the trade you make by not hedging could become a very expensive one.

— Tobias Young is the Head of Hydrocarbons at the Dubai Gold & Commodities Exchange (DGCX)