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Global markets have become unpredictable in recent years, highlighting that companies need to update their risk mitigation plans. Price volatility comes from factors that companies cannot control but can still impact their profits and stability. For example, these changes can affect financial results, stock prices, and borrowing costs. Strong hedging programs can help reduce the ups and downs in economic performance and cash flow, keeping investors confident with more stable and predictable results. Here is an overview of how you can manage risks effectively to handle uncertainties better and even succeed in challenging conditions.
Key Factors Contributing to Volatility
Interest Rate Fluctuations Impact Financial Asset Values
One major issue is the changing interest rates. These rates affect how much it costs to borrow money, the returns on investments, and the value of financial assets. Historically, the US overnight financing rate has averaged 2.3%, but it reached a high of 5.4% in January and July 2024.
This rapid rise in interest rates has led to lower values for fixed assets, as seen in financial reports showing significant unrealized losses in available-for-sale securities. As interest rates are expected to keep dropping in the US, businesses may continue to experience changes in the value of fixed assets through 2025.
Currency Volatility Presents Additional Financial Challenges
International enterprises that deal with foreign currencies face challenges. When the US dollar strengthens against other currencies, it affects the value of earnings from abroad and impacts their finances. Economic risks can include future costs for raw materials or sales of goods priced in foreign currencies. They can also involve contracts that change with currency exchange rates, price adjustments, or investments and debts in foreign currencies.
Commodity Price Surges Drive Up Costs and Squeeze Margins
In 2024, prices for some commodities rose sharply, which made things more complicated. Copper and gold hit record-high prices. Oil prices, which had fallen below zero for the first time in April due to pandemic restrictions, will continue to fall, experts say. From an average of $81 per barrel in 2024 to $74 in 2025, they might end up at $66 in 2026 These price changes can impact production costs, profit margins, and overall financial performance.
Geopolitical Tensions and Inflation Continue to Fuel Market Uncertainty
Market risks aren’t the only worries; inflation and geopolitical tensions also create instability. In June 2022, the U.S. Bureau of Labor Statistics reported the largest rise in the Consumer Price Index since 1981, with an increase of 9.1%. A report from EY-Parthenon in November 2024 predicts that inflation will decrease into early 2025. However, changes like deregulation, immigration restrictions, tariffs, and tax cuts could raise inflation again in 2025 and 2026, leading to higher interest rates.
Identifying and mitigating exposures
Balancing Risk and Opportunity in Volatile Markets
Firms can use market ups and downs to save costs and increase profits. On the other hand, this uncertainty can also bring uncertainties, like higher expenses and lower profit margins. Because volatility can be helpful and harmful, companies must create a balanced approach that manages risks while seizing opportunities. One option is to pass these liabilities onto customers or to use natural offsets. Another choice is to use financial derivatives, which can help reduce risk but can also be complicated.
Derivatives and the Complexity of Hedge Accounting
For instance, even though the goal is to decrease volatility and risk, derivatives can contribute to higher volatility in financial statements, as fair value changes in derivatives are recorded on the balance sheet at their fair value, with any changes reflected in earnings. Entities can implement hedge accounting for qualifying transactions if specific criteria are satisfied. If the derivative does not qualify as a hedging instrument, the corresponding side of the journal entry is recorded as income.
If the derivative qualifies for hedge accounting, it is properly assigned and works effectively as a hedging tool. What you record in the journal will depend on whether the derivative is part of a fair value hedge, a cash flow hedge, or a hedge of a net investment in a foreign operation.
Aligning Derivative Choices with Risk Strategy and Compliance Goals
After identifying risks and creating a strategy, organizations must choose the right derivative products for their needs. The main types of financial derivatives related to interest rates, foreign exchange, and commodities include:
For interest rates: swaps, caps, floors, collars, and swaptions.
For foreign exchange: FX forwards, options, and cross-currency swaps.
For commodities: futures, swaps, and options.
Hedge accounting can help manage the changes in financial statements caused by these derivatives by showing a clearer picture of the company’s risk management. However, hedge accounting has complex rules. Companies should ask themselves these questions before deciding to use it:
How well do you understand your company’s exposure liability? Is your playbook strong enough to handle those uncertainties?
How does your organization manage earnings ups and downs through a hedging program?
Can your team analyze data and provide better reports after spending time on manual tasks, compliance work, and valuations?
Are you aware of the risks of your hedging program, and do you have access to the necessary reports?
How scalable, automated, and efficient are your current processes and operations regarding using derivatives?
Do you use hedge accounting? If not, do you have the resources to meet compliance requirements?
Answering these questions can help companies create a flexible strategy that lowers risks and allows them to take advantage of opportunities.
Managing Volatility: To Hedge or Not to Hedge?
There is no single solution for managing volatility so that companies can hedge or accept the natural downsides from their operations. For example, a financial institution with one-year liabilities and shorter-term assets might accept interest rate changes if it expects rates to rise. This could lead to higher returns on their variable-rate assets.
Alternatively, they can use derivatives to create liability exposure, such as entering into an interest rate swap where they pay a fixed rate and receive a floating rate, which acts like floating-rate assets. Additionally, a company with foreign currency risks that believes its currency will decrease in value against the US dollar could enter into a forward contract.
Managing the Operational Lifecycle of Financial Derivatives
Using financial derivatives brings additional operational challenges that organizations must manage throughout their lifecycle. Initially, trade decision-making involves identifying which trades to pursue. Trade execution then involves completing the derivative transaction with a counterparty while securing the best pricing. After that, trade capture requires documenting the derivative’s terms in the record system.
Next, confirmation and affirmation involve validating the trade terms with the counterparty. Settlements and reconciliations deal with cash movements and matching fair values with cash amounts. Collateral management concentrates on managing margins. Furthermore, accounting and hedge accounting are critical for precise financial tracking. Financial reporting necessitates that all derivative activities are clearly and thoroughly documented in financial statements.
Essential Capabilities for Effective Derivative Risk Management
To effectively manage volatility risks, organizations may create an in-house solution, adopt a third-party solution, or choose a hybrid solution for various aspects of the derivative trade lifecycle. The appropriate support should encompass the following areas:
Sustained hedge accounting and derivatives valuation that are adaptable and scalable.
Analytical support for hedging, procurement, trading activities, and hedge performance measurement.
Risk management insights into hedge effectiveness, portfolio exposure, and sensitivities to market uncertainty.
Assess peers, competitors, and industry disclosures to gain insights into their expected effects on financial reporting and to offer valuable benchmarks.
Training and ad hoc support to prepare teams for risk management and implementing effective hedging strategies.
As outlined previously, operational functions regarding derivative instruments (from trade decision-making to reporting).
Even if organizations decide against employing hedge accounting, they still require the operational capabilities to manage the trade lifecycle. Having a dedicated in-house or third-party solution can assist in navigating the complexities and identifying the most effective strategies.
Conclusion
In today’s unpredictable market, managing risk is essential for financial stability and business continuity. Changes in interest rates, currency values, commodity prices, and global events will continue to affect financial results in 2025 and beyond. By identifying threats early, developing a strong hedging strategy, and maintaining effective processes for handling derivatives, organizations can protect their cash flow, stabilize earnings, and keep investor trust.
Whether enterprises choose to hedge or manage risks through their daily operations, having the right tools and support is crucial. A flexible and well-managed approach helps businesses deal with market challenges and take advantage of new opportunities when conditions improve.
