Energy Hedging with Derivatives — Applications
Once the board has authorized and established policies and procedures for the risk management program, senior management must execute the strategy; in other words, they must start using energy derivatives to hedge. As touched upon in previous chapters, hedging is the process in which an organization with energy price risk takes a position in a derivative instrument (swaps, options, futures) that gives an equal and opposite financial exposure to the underlying physical position to protect against major adverse price changes. The volumetric price exposure of the derivatives hedging instrument should be equal and opposite to the price exposure of the physical energy commodity that the organization wishes to reduce its price risk exposure in. It is important for Board of Directors to take hedging very seriously. A prime example of how serious it can be if you don’t let your company hedge are some legal cases where courts have found that directors have had a legal duty to mitigate commodity-linked price risk exposure. An early example of this was in 1992 in the United States, shareholders of a grain cooperative claimed that the directors breached their fiduciary duty by failing to protect the cooperative’s profits through hedging in the futures market (Brane v. Roth, 590 N.E.2d 587 (Ind. CT. App. 1992)). The Indiana state court agreed and awarded the shareholders compensation!
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