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This step involves determining the optimal level of safety stock to handle unexpected demand spikes or supply delays. It serves as a buffer to mitigate stockouts and maintain customer service levels. A strategic inventory ensures swift adaptation to market changes and trends. In the index space, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than with more severe ones.

A dip in the market or a price shock for a commodity of interest might trigger a hedge. The purpose of a hedge is to protect; thus, a hedge position is undertaken to reduce risk. In some cases, the one placing the hedge owns the commodity or asset, while other times the hedger does not. The hedger makes a purchase or sale of the futures contract to substitute for an eventual cash transaction.

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While no earnings impact will arise from the appreciated inventory, the put would likely generate a relatively small cost as a consequence of the put’s time decay. Over the life of the hedge, the loss on the put would be limited to the price paid for the put, which inevitably will represent a small portion of the value of the inventory being hedged. Hedge inventory is a risk management strategy to mitigate potential losses due to price fluctuations, but it does not guarantee profit.

Either way, businesses that hedge inventory believe they are mitigating risk by stockpiling excess inventory in this manner. That being said, hedging inventory comes with its own significant set of risks that we will touch on later in the article. For large corporations with centralised treasury functions, it’s common for one entity to contract a derivative to hedge a risk to which another group entity is exposed. IFRS 9 does not prohibit such arrangements from being accounted for using hedge accounting principles in consolidated financial statements. Ideally, the purchase price of the put option would be exactly equal to the expected downside risk of the underlying security. However, if this were the case, there would be little reason not to hedge every investment.

Safety Stock:

By purchasing a put option, an investor is transferring the downside risk to the seller. In general, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be. We hope that you now have a better understanding of what strategic inventory is, its significance, and how to implement our strategic inventory management process. Regularly review inventory levels, demand forecasts, and supplier performance. Strategic inventory guards against unexpected supply chain disruptions to ensure business continuity and prevent revenue losses.

This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their heads.

Big pawnshop companies see inventory rise

In terms of the example posed above, if we decide to hedge the full exposure of 100 units, our hedge should likely be an inventory hedge through March 31, and thereafter it should be a hedge of the projected sale. To properly hedge inventory, it is essential to have a strong hedging policy, uniform hedge financial reporting, a control system with accurate targeted reporting, as well as professional advice and risk modeling. The opposite is true in a hot market, and for a producer of low margin, large commodity value goods, the impact on income statements and working capital can be downright nasty. You wouldn’t realize this from checking at your bank accounts & income records, but the risks are still effectively offset. Economic neutrality is maintained because the valuation of the stock can be readily countered by the reverse valuation of the active future hedge; however, what occurs to cash flow? This should be the issue; currently, accounting, commercial, and hedging treatments are all at odds with one another and have very unexpected results.

In this article, we’ll define hedging inventory, discuss when a business should consider inventory hedging, and review the risks of ordering too much inventory. Entities must assess whether a hedging relationship meets the hedge effectiveness requirements at each reporting date or when there is a significant change in circumstances. This assessment is forward-looking, focusing on expectations about future hedge effectiveness (IFRS 9.B6.4.12). It may occur that the transactions of a business to be acquired qualify as a hedged item, provided they can be considered a highly probable forecast transaction from the perspective of the acquirer. If in six months the value of the stock she purchased has increased to $16, Sarah will not exercise her put option and will have lost $7.