Spero Consulting can integrate risk management methods and policies into various planning and operating activities, including raw materials purchasing and supply chain management.
Strategic Risk Management
Firm-wide, we take a holistic approach to combining uncertainty management and managerial control—defined as determining the means to attain the organization’s objectives.
We consider how a firm can benefit or profit from its uncertain environment, rather than merely insulate itself from variability of input and output prices. So, we attempt to maximize the projected difference between revenues and costs by understanding environmental uncertainty and variability and relationships, including how customer and supplier responses to different conditions and how those likely responses can be used to your firm’s benefit.
For example, for long-term projects or deliveries, we can determine appropriate risk-mitigation techniques to determine whether your firm could earn a sufficient risk premium from its customers to justify such an upfront guarantee?
Tactical Risk Management
Many firms are interested in narrower projects that involve:
- Determining and implementing market-based methods to improve your long-term forecasting objectivity, accuracy and reliability, and
- Analyzing and implementing appropriate “hedges” to minimize raw material price volatility.
Market-based Planning:
Often, markets–whether cash or derivative–for raw materials are not well-developed, but one can still use available forward or future information to make planning and budgeting processes more objective and systematic and (therefore) less based upon any individual’s (idiosyncratic) beliefs about the future.
Such an approach is imperfect of a number of reasons—including the incompleteness of the markets and the limited number of participants—but does provide the firm with a consistent planning process that can be used for all commodity-based inputs. (Because it is imperfect, there is still be a need for sensitivity analysis, including stress testing and scenario analyses, which are described below.)
Hedging:
For non-financial firms with little institutional experience in this area, we provide the following services to profitably manage risk. (Usually performed in order.)
- Training or explaining the basic notions in the field.
- Investigate potential “hedges” and their suitability, including determining costs, benefits, and risks of hedging, including basis risk.
- Perform sensitivity analyses, stress-testing, and scenario analyses.
- Develop ongoing decision rules and policies. (Giving the incomplete and changing markets, it is unlikely that a single policy, e.g., “always hedge,” will be optimal. Instead, we would provide decision rules, i.e., if x is greater than y, and w is greater than z, then hedge…)
- Evaluate effectiveness (performance) of new policies.
One of our tag lines is, “Thought before Calculation™ ” because we try to eliminate the possibilities and costs of unintended consequences. Clearly, for a manufacturing firm with limited experience, delving into new types of commodities and derivatives markets and trading can be quite perilous and expensive. Fortunately, our expertise is rather unique and spans both managerial control and risk management; so, we perform all six steps.
1. Training
We provide individual or group training at each step. It is crucial to develop a common vocabulary so that all managers and employees use the same terms and phrases in the same way.
2. Research & Analysis of Available Hedges
With our mathematical and statistical expertise we can investigate potential, market-based “hedges” and their suitability. (The word “hedges” is almost always surrounding by scare quotes to emphasize and remind that there are few perfect hedges, i.e., the possibility exists to lose on both sides. That is basis risk.)
The suitability of hedging with a particular market instrument (or set of instruments) involves determining the costs, benefits, and risks of those instruments, including basis risk that would arise from imperfectly “hedging” one grade of a commodity with another.
We provide a full set of measures to identify and capture those risks–either with respect to errors related to (a) probabilities or (b) magnitudes–and we perform sensitivity analyses or “what-if” analyses to capture the robustness of tactics and losses associated with mistakes.
3. Perform Stress-testing and Scenario Analysis, including Back-testing
Risk is the narrower (measurable) set of uncertainty. (See this essay on Uncertainty Management.) Stress-testing, and scenario analysis are used to determine the magnitude of losses outside a standard statistical analysis.
Scenario analysis can be hypothetical, e.g., “what if China does…,” or it can be historical, “what if prices fall like they did in 2008.” In the latter case, we would take either the absolute or proportional change in prices during, say, some period in 2008, and apply that to your custom trades or market contracts to determine the profit or loss effects.
Usually historical scenario analysis looks at changes in market prices or factors at two points in time, whereas a back-test applies a trading rule or hedging strategy to a (historical) sequence prices to see how the trade or “hedge” would have performed in those market conditions.
4. Develop Decision Rules
Taken together, the analyses described can be converted into decision rules, which allow clients to determine whether to “hedge” or not depending upon the present combination of market and other variables. (While we are always available to assist our clients, generally, firms do not need us to make a recommendation for every purchase decision.
5. Routine Reporting and Back-testing
We develop routine reports, including reports that include profit-and-loss measurement, sensitivity analyses, stress-tests, scenario analyses, and back-testing. Like any control mechanism, such feedback is useful to refine and adjust ongoing risk management and mitigation activities.
To learn more or to arrange a meeting, please call 412.779.9028 or contact Spero Consulting.
