Hedging Strategy Analysis for Sims Metal Management
The Risks Faced by Sims Metal Management
Sims Metal Management (SGM) is a global Australian-based company that specializes in metal recycling, operates business in North America, Australiasia( Australia and Asia) and Europe, with North America being the largest market. The company’s activities expose it to the three major parts as financial risks: market risk, credit risk and liquidity risk.
Market risks consist of interest rate risk, foreign exchange risk and commodity price risk. Firstly, SGM’s main exposure to interest rate risk is its borrowings at variable interest rates. As a result, the value of their financial instrument or cash flows will fluctuate. This risk constantly exists and is of significant importance to the company’s cash flows. Secondly, SGM operates internationally, so it is exposed to foreign exchange risk, primarily with respect to transactions settled in US dollars. Foreign exchange risk arises when future commercial transactions and recognised assets and liabilities are denominated in a currency that is not the entity’s functional currency. Lastly, SGM is also exposed to risks of market price fluctuations. While SMG strategically focuses on recycling, more than 70% of its revenue comes from producing recycled ferrous and non-ferrous metals. The fluctuation of the price of both the raw materials and the recycled metals will affect the group’s revenue and cash flow directly (SMM annual report, 2011).
On the other hand, credit risk and liquidity risk are also challenges that SGM faces. As for credit risk, which refers to the case where the counterparty will not complete its obligations under a financial instrument and cause a financial loss to the company. So far, SGM has exposure to credit risk on all financial assets and transactions in derivative contracts. Liquidity risk also arises when SGM has insufficient access to capital to fund growth projects or settle a transaction on the due date. As a result, the company would be forced to sell financial assets at a value which is less than what they are worth or refinance the Group’s borrowing facilities (SMM annual report, 2011).
Figure 1 show the risks faced by SMM briefly.
Risk Management of Sims Metal Management
The overall financial risk management strategy of SGM seeks to mitigate risks to minimize potential adverse effects on the financial performance. Risk management is carried out by a limited number of employees as authorised by the Board. In this report, we focus on the derivative and non-derivative financial instruments that used by the company. Firstly, we elaborate how SGM hedges its exposure to currency fluctuations in foreign exchange rates and commodity prices with derivative financial instruments. Then we briefly show how they deal with interest risk, credit risk and liquidity risk using methods other than derivatives.
In terms of foreign exchange risk management, to protect against exchange rate movements in relation to material purchases and sales and underlying transactions between subsidiaries, SGM enters into forward foreign exchange contracts to buy and sell specific amounts of various foreign currencies in the future at predetermined exchange rates. The forward foreign exchange contracts are used to hedge transactions denominated in currencies which are not the functional currency of the relevant entity. These contracts are hedging highly probable forecasted transactions for the ensuing financial year. The contracts are timed to mature when monies from the forecasted sales are scheduled to be received or when payments for purchases are scheduled to be made. On a limited basis, the company also utilizes option contracts to hedge its foreign currency exposure (SMM annual report, 2011).
In terms of commodity price risk management, SGM enters into forward commodity contracts matched to purchases or sales of metal and precious metal commitments. These contracts...
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