How would a corporate hedge a key commodity input cost, and what basis risk should it watch?
A core Corporate Treasury interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
A manufacturer exposed to a raw-material price (energy, metals, agricultural inputs) can hedge with commodity derivatives — futures, forwards/swaps fixing the price, or options/collars to cap cost while keeping downside. The policy mirrors FX: define the exposure (volume and horizon), the hedge ratio and tenor, and the instruments, in a board-approved framework, and prefer operational/natural hedges first (pass-through pricing clauses, indexing customer prices to the input, supplier contracts). The big watch-item is basis risk: the traded contract rarely matches the exact grade, location, and timing the company actually buys, so the hedge and the physical cost can diverge — e.g., hedging jet fuel with crude, or a regional gas price with a different hub. You also have liquidity/margin risk on exchange-traded hedges (variation margin), correlation breakdown in stress, and hedge-accounting designation to avoid P&L volatility. So you hedge the economic exposure, accept and minimize basis by choosing the closest contract, and size to risk appetite rather than trying to perfectly match physical purchases.
WHAT INTERVIEWERS LISTEN FOR
- ✓Hedge with commodity futures/swaps/options or collars within a policy
- ✓Use operational/natural hedges first (pass-through, indexed pricing)
- ✓Basis risk: contract grade/location/timing ≠ physical purchase
- ✓Watch margin liquidity, correlation breakdown, hedge accounting
COMMON MISTAKES
- ✗Ignoring basis risk between the hedge and physical input
- ✗No natural/pass-through hedge consideration
- ✗Forgetting margin/liquidity on exchange-traded hedges
Reading isn't the same as answering under pressure.
Interviewers don't hand you the model answer — you deliver yours on a clock. Practice this and 1,000+ questions with AI feedback on every answer.
RELATED QUESTIONS
- Explain an interest rate swap.
- Explain IFRS 9 hedge accounting.
- Explain counterparty risk in derivatives and how it's mitigated.
- Explain the fixed/floating decision.
- Explain mark-to-market on a derivative.
- A company enters into a 5-year receive-fixed interest rate swap to hedge a variable-rate loan. The loan is prepaid after 2 years. Under IFRS 9, the swap was designated as a cash flow hedge. What happens to the hedge accounting and the swap?