Forget Derivatives – Hedge Risks with Innovation and Integrated Data

August 3, 2011
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To protect against wild currency swings or volatile commodity costs, one surefire strategy employed by senior managers is hedging risk with derivative contracts. However, some companies are discovering alternative methods to guard against uncertainty via two strategies—product innovation and integrated data.

To protect against wild currency swings or volatile commodity costs, one surefire strategy employed by senior managers is hedging risk with derivative contracts. However, some companies are discovering alternative methods to guard against uncertainty via two strategies—product innovation and integrated data.

In a recent Fortune article, author Becky Quick cites methods for dealing with tumultuous changes in our global economy. In addition to “natural” risk hedges against currency storms such as bringing production of goods back to home markets, Quick mentions that companies look to hedge risks against commodity price fluctuations by purchasing futures, options, or similar financial products.

And while companies from soda manufacturers to global airlines use such structured products to protect themselves from perfect storms, derivatives aren’t a complete panacea, especially for un-sophisticated players. “Companies enter into transactions that are rarely understood,” says derivatives expert Satyajit Das. In addition, he says, “(These) complicated (derivative) structures make it hard for clients to price (them).”

Instead of trying to “out-think” markets, Quick gives an example of Proctor and Gamble relying on “good old fashioned engineering and science” to innovate its way out of commodity price risks. She says Proctor and Gamble doesn’t bother buying derivatives.  Instead, the company looks at alternative packaging options and sometimes substitutes for price sensitive ingredients. For example in one hair care product, biodegradable cornstarch was substituted for pricey petrochemical resins, saving millions in costs.

In addition to innovation, another risk management avenue is merging disparate data sources from sales, marketing, inventory, finance etc into an integrated foundation. With integrated data, company managers can peer deeply into various departments or divisions and perform cross functional analysis. Integrated data means that senior managers gain a 360 degree view of business conditions. Managers can now see how one decision impacts other aspects of the organization. And with everyone in the company marching to the same drum-beat—making decisions from a “single source of truth”—it’s much easier to produce coordinated and flexible responses when extreme events such as supply chain disruptions or other “once in a century events” occur.

Derivatives – a $60 trillion dollar business – aren’t going away any time soon. But innovation and integrated data provide much more than simple risk management.

Innovation provides an opportunity for cost take-out and game changing products or services. And maintaining integrated data across multiple functional areas (finance, operations, customers, suppliers etc) allows for increasing risk management sophistication as a business can be managed as “as a whole”.  Armed with a more complete picture of business conditions, executives can steer their company through chaotic economic conditions and find safe harbors in explosive market storms.