Commodity volatility and elevated inflation levels have stolen the headlines through most of 2022. Explosive energy, battery materials, forest products, and agriculture prices have altered the landscape for many businesses.
The current market dynamics could remain in place, as inflation can remain stubbornly high for an extended period.
High levels of inflation tend to generate uncertainty and volatility. When volatility impacts a company’s profits, it can reduce investor confidence and create a dynamic where risk aversion gains traction.
One of the best ways a company can determine if the volatility of its returns is beyond what investors want to accept is to use a Sharpe Ratio to measure its profitability.
What is a Sharpe Ratio?
The Sharpe Ratio is a risk management statistic used to measure the consistency of returns. The ratio compares the average return on an investment relative to the standard deviation of the returns on investment.
The Sharpe Ratio represents the gains you generate per each unit of volatility. The standard deviation is a statistical measure of the variance from the average and is used to calculate volatility.
The numerator of the Sharpe Ratio also removes the risk-free rate of return, such as a benchmark like a treasury bill. The average return is the profit you generate above what can be generated without taking risks.
Sharpe Ratio = Average Return (minus risk free rate) / Standard Deviation of Returns
Why is the Sharpe Ratio important?
Understanding the returns you produce is essential. Volatile returns might be alarming and can reduce confidence.
Here is an example of how understanding the Sharpe Ratio can impact investment decisions.
Let’s say you can choose to invest in company ABC or XYZ. Both companies have an average return over a year of 18%.
Company A has steady returns, all steady gains. The standard deviation of those returns is about 1.25%.
Company XZY also has an average return of 18%, but the profitability was erratic and lumpy. In several months there were vast gains of more than 25%, and in some months, there were losses of more than 20%. The standard deviation of company XYZ’s returns was 21%.
The Sharpe Ratio for company ABC using a risk-free rate of return of 3% is 12 = (18% average minus 3% risk-free rate)/ 1.25% standard deviation of returns.
The Sharpe Ratio for company XYZ using a risk-free rate of return of 3% is 0.70 = (18% average minus 3% risk-free rate)/ 21% standard deviation of returns.
Company ABC has a Sharpe Ratio of more than 17-times better than the Sharpe Ratio of company XYZ.
ABC provides you with a much better return for the same level of volatility.
Hedging can help you increase your Sharpe Ratio
The returns you generate for your business should be determined by owner/investor appetite.
Calculating these metrics allows you to decide the type of returns your investor desires. If your goal is to risk a lot on the direction of your feedstock variable cost, or your production, then hedging is likely less helpful than a company looking to lock in growing stable margins.
By commodity hedging a portion of your portfolio, you can manage your Value at Risk to enhance your Sharpe Ratio to its optimal level.
How can you optimize your Sharpe Ratio?
You can start optimizing your Sharpe Ratio by analyzing the volatility of your returns relative to your average return.
To determine the volatility of your profits, you would start by evaluating whether a significant change in your input costs would impact your earnings. If the answer is yes, you want to calculate how much the variation in your feedstock costs alters your profits.
For example, if your commodity input costs determine 90% of your profits, then the volatility of your returns will be generated mainly by commodity price changes. By fixing your input costs using a commodity hedging technique, you can reduce your company’s earnings volatility and increase your Sharpe Ratio.
If you are looking to optimize your Sharpe Ratio and want to know how you can reduce the risks associated with your commodity price risk, feel free to contact our Risk Solutions Team.