Risk management and performance impact - Hedging policies an...

Learning Outcomes

This article explains core risk management concepts for ACCA Advanced Performance Management (APM). You will learn to identify business risks impacting performance, describe and compare hedging techniques used to manage these risks, and assess how hedging affects key performance indicators. By the end, you should be able to evaluate risk-adjusted performance metrics and advise on transparent disclosure in performance reporting.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand how risk management—particularly hedging—affects both strategic decision-making and performance measurement. In revision, focus on:

• Identifying and classifying business risks relevant to organisational objectives
• Explaining the rationale for risk management, including use of hedging policies
• Distinguishing between operational and financial hedging techniques
• Evaluating the effects of hedging on reported results and performance measures
• Recommending performance metrics that account for risk management outcomes

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which main objective does a hedging policy address in risk management?
   1. Maximising speculative returns
   2. Erasing all organisational risk
   3. Reducing adverse performance impacts from specific risks
   4. Minimising operational expenses
2. A company manages commodity price risk by locking in costs with a supplier for 12 months. This is an example of:
   1. Financial hedging
   2. Insurance
   3. Operational hedging
   4. Market risk analysis

3. True or false? Including hedging gains or losses in reported profit always provides a clearer view of management performance.

4. Explain why risk-adjusted KPIs may be necessary when assessing divisional performance.

5. Name one quantitative metric and one qualitative disclosure commonly used to evaluate hedging effectiveness.

Introduction

Organisations operate in environments where uncertainty from external factors—such as foreign exchange movements, fluctuating commodity prices, and interest rates—can disrupt plans and distort reported performance. Risk management, and specifically hedging, enables managers to mitigate unwanted effects these factors have on financial results. Understanding how hedging strategies are designed, executed, and reflected in performance measures is essential for accurate assessment of business outcomes and management skill.

Key Term: risk management
The process of identifying, analysing, and responding to threat factors that may prevent the achievement of organisational objectives.

Risk Types and Hedging Rationale

Effective performance management must distinguish between performance outcomes arising from management action and those caused by uncontrollable risk factors. Risks affecting performance typically include:

• Foreign exchange risk (e.g., revenue/costs in multiple currencies)
• Commodity/energy price risk
• Interest rate risk
• Credit/default risk

Unhedged risks may generate volatile financial results, making it difficult to assess true management performance or compare results across periods.

Key Term: hedging
The use of financial or operational methods to reduce or neutralise the financial impact of unwanted risks on business performance.

Types of Hedging Approaches

Organisations select hedging methods based on risk appetite, cost, and operational factors. Common approaches include:

• Financial hedging: Use of financial instruments (forwards, options, swaps, futures) to lock in prices, exchange rates, or interest rates and reduce variability in cash flows.
• Operational hedging: Changing business processes or structures (e.g., sourcing from multiple suppliers, geographic diversification) to reduce risk exposure.
• Insurance: Transferring risk to a third party (e.g., property insurance, credit insurance) in exchange for a premium.

Key Term: financial derivative
A financial contract whose value is based on the price of a reference asset, commonly used to manage exposure to financial risks.

Key Term: operational hedging
The modification of business activities or supply chains to limit the financial impact of adverse external events.

How Hedging Influences Performance Measurement

Hedging can stabilise profit and cash flow by removing or reducing the effect of uncontrollable variables, such as currency fluctuations or raw material price volatility. Accordingly, performance metrics—such as operating profit, ROCE, EBITDA, or risk-adjusted return—can better reflect managerial effectiveness if hedging outcomes are transparently included and analysed.

However, hedging introduces direct costs (e.g., premiums, transaction fees, or lost upside potential), and the effectiveness of the hedge should itself be evaluated. Omitting hedging impacts from reported metrics may mislead users of financial information.

Key Term: risk-adjusted performance
Measurement of outcomes that considers both realised results and the risk management strategies applied, usually adjusting for the cost/effectiveness of those strategies.

Worked Example 1.1

A company exports goods and expects to receive $1.2m in six months. Management is concerned about a possible fall in the USD/GBP rate. To hedge, they enter into a forward contract fixing the GBP receipts.

Question:
If the dollar weakens but the forward rate is used, how does this affect performance measurement?

Answer:
The forward contract eliminates exchange rate risk, so sales revenue in GBP is unaffected by market movements. Profit reflects core trade performance, not exchange rate volatility. Stakeholders see a stable result attributable to management planning.

Worked Example 1.2

A food manufacturer expects to use 500 tonnes of wheat over the next year. Wheat prices are rising, but the manager delays hedging, hoping for a price drop. Prices surge, causing a significant fall in profit.

Question:
What is the impact on performance evaluation and KPIs?

Answer:
Failure to hedge exposes profit to market risk, causing volatile outcomes and reduced comparability between periods. KPIs like operating margin and ROCE fall due to external price increases, masking operational performance. Management may be criticised for failing to manage risk appropriately.

Hedging Effectiveness and Performance Metrics

To assess the impact of hedging on performance, organisations should:

• Compare pre- and post-hedging results to demonstrate the effect of risk management (e.g., reduced profit variability)
• Analyse the cost of hedging relative to the protection gained
• Use quantitative measures such as volatility reduction, Value at Risk (VaR), or Risk-Adjusted Return on Capital (RAROC)
• Disclose the nature, extent, and results of hedging activities in performance reports

If hedging outcomes are significant, present supplementary disclosures or adjusted KPIs to enable a fair assessment of management actions and risk outcomes.

Worked Example 1.3

A retailer faces interest rate risk on floating-rate debt. Management swaps its exposure to fixed-rate, incurring an upfront fee.

Question:
How should the effects be incorporated into performance measures and reports?

Answer:
The fee and swap results should be recognised in profit. Reports should show both the baseline finance cost and the impact of the hedge. Adjusted KPIs may be provided, showing risk-adjusted net interest or earnings volatility before and after the hedge, to support transparent performance evaluation.

Exam Warning

In APM questions, check whether hedging gains and losses are correctly included (or excluded) in performance calculations. If hedging effects are omitted, any analysis of KPIs (e.g., profit, ROI) may be distorted—leading to poor exam marks or flawed arguments.

Designing KPIs and Disclosure for Risk-Adjusted Performance

When designing and evaluating KPIs for an entity using hedging strategies:

• Disclose the cost and outcome of hedging policies within profit and key metrics
• Supplement headline figures with risk-adjusted results or at least narrative descriptions of hedging impact
• When relevant, compare volatility of results (e.g., standard deviation of profit) before and after hedging implementation

This approach ensures assessments are based on both management’s control over operations and their approach to risk management, providing a clearer picture for stakeholders.

Revision Tip

Always check if gains/losses from hedges are reflected in reported KPIs. Recommend explicit disclosure where hedging materially affects results, especially for incentive or investment decisions.

Summary

Hedging policies are central to risk management and influence the credibility of performance metrics. Proper hedging can stabilise profits, improve forecast accuracy, and support fair appraisal of management skill. For accurate evaluation, performance measures must reflect both the direct results of hedging activity and any residual exposures. Transparent reporting and clear KPIs help prevent misinterpretation and support sound decision-making.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify key business risks that affect performance management
• Explain financial and operational hedging techniques
• Evaluate the impact of hedging policies on reported results and performance metrics
• Recommend adjustments to KPIs and disclosures for risk-adjusted measurement
• Recognise common exam pitfalls related to hedging and performance evaluation

Key Terms and Concepts

• risk management
• hedging
• financial derivative
• operational hedging
• risk-adjusted performance