Allstate Corporation and Kraft Foods are two corporate leaders with very different products. But both hedge their risk through CME Group. Here's how.
Hedging is a term that does not sound all that critical. But with the bottom falling out of world markets recently, risk management has taken on greater importance, often amounting to a starring role.
CME Group Magazine recently discussed the subject with two companies at the forefront of their fields who have weathered the downturn rather well - Kraft Foods, one of the world's largest food companies, and Allstate Corporation, the largest publicly held personal line insurance company in the United States. Although their industries are different, a number of similarities emerged in their risk management strategies.
Kraft Foods
Jack Bienkowski, senior director of commodity risk management at Kraft Foods, has a favorite term to describe the marketplace today - "turbo-charged."
"Globalization, the speed of information, the vastness of the marketplace - all of these things have combined to dramatically expand the volatility of the commodity markets," Bienkowski says. "The distance from high to low is so much greater than it used to be. Also, markets are much more interconnected now. So if you hedge a position and you're wrong, you can be wrong in a really big way."
Working with the other members of his staff, Bienkowski is responsible for managing Kraft's price risk and worldwide supply chain as transparently as possible. In effect, it means matching fluctuating commodity prices with a retail marketing strategy that is "frankly unmovable" in the short term. Consumers expect the prices they pay for food products, such as Kraft Macaroni & Cheese in the United States or the Lu brand of cookies in Europe, to be relatively stable from week to week. The company's risk management plays a major role in ensuring that they are.
Bienkowski and his staff use CME Group futures and options to hedge a diverse portfolio of commodities such as dairy and meat, grains, soybean oil and energy products.
"We have an approved strategy for every commodity. And it gets revisited on regular basis so we can make adjustments as world developments unfold every day."
Adoption of CME ClearPort
Bienkowski singles out Kraft's adoption of the CME ClearPort service as one of the more successful new strategies that they employ. For more than a year, Kraft has used the over-the-counter (OTC) market service to clear highly customized energy products.
"With CME ClearPort, your counterparty is the exchange's clearing house," says Bienkowski. "Not only has it created a higher comfort level but it has helped to mitigate more of the risk than we were able to before."
Another major adjustment has been the switch to electronic trading, which Bienkowski's group began using this summer. "I personally welcome it. You can't get more efficient."
Information overload
Progress, however, also brings challenges. With so much market information at one's fingertips, Bienkowski and his group avoid information overload by prioritizing and reducing the variables to a manageable number. They also are approaching risk management with a broader perspective.
"Macroeconomic analysis now has become part of our individual commodity analysis," Bienkowski says. "We're forced to look at factors such as CPI data, unemployment, and the shape of the recovery. We never used to do that in commodity risk management. But with globalization, it's become a necessity."
Allstate corporation
Like Kraft, Allstate also is taking a more macro approach to its risk management, according to Dan Busiel, senior portfolio manager, who oversees all derivatives activity for the insurance leader.
"Initially, we were focused on eliminating the specific risks embedded in our products and investments," Busiel says. "But we're now looking at our portfolios more holistically, trying to aggregate risk where possible. It's much more difficult than it is for non-insurance companies because we have to incorporate accounting and tax rules, regulatory constraints and capital requirements. But given the big moves in interest rates and the equity markets, aggregating risks is absolutely essential if you want to run an efficient, cost-effective risk management program."
Typically, insurance companies try to match their assets with their risk exposure, such as the rate component embedded in life insurance policies. But the match-ups are not perfect. So to cover the residual "net exposure" Allstate and other insurers seek greater liquidity through such instruments as Treasury futures, Eurodollar futures, interest rate swap futures and options on these instruments.
Allstate, for its part, uses a broad range of CME Group products to "sculpt its risk profile," according to Busiel, including, surprisingly, commodities.
Commodities as Diversifier
"We made the decision a few years back that we wanted some commodity market exposure to further diversify our investment portfolio," Busiel explains. "Initially, this took the form of exposure to the S&P GSCI commodity Index. The position was always very small as a percentage of our total portfolio. But to put that into perspective, our total portfolio is about $100 billion."
As with Kraft, Allstate has become more concerned about counterparty exposure.
"We always had a healthy mix between OTC and exchange-based products, but in a post-Lehman world, the liquidity and the counterparty comfort associated with the exchanges are worth a lot more today," Busiel says. "And the OTC markets are not as efficient as they used to be. It costs more to transact in those markets. Consequently, we've been migrating more toward exchange products."
Busiel anticipates that the OTC market will evolve structurally toward the exchange model as demand grows for greater counterparty assurance and liquidity.
Like Bienkowski at Kraft, Busiel sees the innovation of electronic trading in a positive light.
"Now you have access to almost all the markets almost all the time. It gives you reassurance that if you need to transact immediately, it's pretty easy to do."
Understanding is Foremost
Another point Kraft and Allstate risk managers agree on is the need to thoroughly understand the hedging tools and information being gathered.
"The first component of good risk management is fundamental research," notes Bienkowski. "And today that research has to include the interrelationships between commodities – something that wasn't as important as in the past."
Or, as Allstate's Busiel puts it, "You need to understand what you're getting involved in. If you don't understand the risk or trust the inputs that are going into your analysis, then you shouldn't trust the output."
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