Misconceptions About Hedging

One would think that after many years’ worth of ‘experience’ with hedging that we would have the subject down pat; that we would no longer have any misconceptions about it. We landed on the moon in ’69, yet we still have various misunderstandings when it comes to hedging.  Some very smart people have been writing about it and/or doing it for a very long time. There are at least two truisms in life that I believe: “…nothing can be said to be certain except death and taxes” (B. Franklin), and effective risk management, which may involve hedging, enhances a firm’s value. Nevertheless, the subject remains misunderstood. Or, as with any subject, there are different opinions on it.

Misconception about Hedging #1: Hedging Eliminates Cash-flow Volatility

This is more of an irony than a misconception, and would depend on a company’s particular situation with its  counterparties (see Strategic Treasurer’s Treasury Update Volume 5 – Spring/Summer 2009). When the posting of cash as margin for the unrealized loss of the hedge portfolio is required, the volatility / unpredictability of cash flow due to margin calls can actually worsen, as opposed to mitigate, hedging’s primary objective, which is generally the predictability of cash flow. Currently this may be situation-specific — dependent on a company’s credit standing and bilateral negotiations with each counterparty, it may, however, become a significant issue for more firms if proposed regulations for the over-the-counter derivatives market end up requiring a central clearing mechanism for all trades.

Misconception about Hedging #2: Risk is Absolute

On the contrary, the perception of how risky an exposure is depends on who you ask, since risk is relative and depends on a company’s (their stakeholders (stockholders, creditors, employees, retirees, etc.) appetite for it. Every organization, even those in similar competitive markets, may approach risk management differently. One firm’s risk appetite, or more specifically, its capacity to absorb risks, can depend on several factors, including: Its business (why it’s in a particular market or product); financial or operating leverage (how much debt or other fixed cash obligations it must endure); liquidity reserves or access to liquidity (its ability to absorb cash flow volatility); or ownership (whether a company is public or private). It’s not always practical to do just what another firm is doing since one approach may not be relevant to another company’s situation.

Misconception about Hedging #3: Risk Management Equals Hedging

Not necessarily. Hedging, or offsetting one’s exposure with an opposing financial position for example, is just one choice in the risk management process. There are three primary choices in addressing risk: Accept it (it’s within your risk appetite), avoid it (you can’t endure it or you choose not to), or manage it, which focuses on either / both changes in operational management or hedging. If you choose not to accept or can’t avoid the risk, then managing it begins at the operational level. Specifically, where can firms reduce their exposure, i.e. make changes in their production inputs, product markets, pricing and/or consumption levels to mitigate exposure? Once undertaken, it’s the residual risk, or the risk remaining, that should be the focus for hedging, only if this risk is still not within the company’s risk tolerance level. Further, hedging should be undertaken to the extent that it brings this residual risk within a firm’s risk appetite.

Misconception about Hedging #4: It’s Important for My Hedges to Make Money

This premise misses the point in hedging (see Strategic Treasurer’s Treasury Update Volume 4, Fall 2008/Spring 2009). While no prudent financial manager consciously makes a decision to lose money, the objective in hedging is more about providing predictability to cash flows or the ability for management to plan, which are two key factors, among others, which contribute to hedging’s impact on a firm’s value. It is not about making money or beating the market, per se, that matters, although many hedges are put in place opportunistically, i.e. to lock-in or secure an attractive level in a commodity or rate – this, of course, is based on one’s perception of the future, which is situational of course. In the end, it’s the net exposure, or the combined value of the exposure, whether interest rate, foreign exchange or commodity price level, combined with the hedge position (level) that matters. The point is, you shouldn’t cheer for your hedges to make money, per se. The primary performance metric to consider is whether you, as risk manager, met your hedge objective, and NOT whether your hedge made money. Too often, the fear of losing money on a hedge is an unfortunate reason for not hedging, which really falls into the realm of speculation. If that is a primary concern, or a risk in itself, i.e. you lock in a level that would put your firm at a competitive disadvantage, then there are other alternatives, including hedging less (this still has to satisfy your firm’s risk constraints) or utilizing options, which give you the right, but not the obligation to lock-in future prices

Misconception about Hedging #5: Derivatives = Speculation

This may be the most common misunderstanding in hedging. Warren Buffet’s now famous quote that “derivatives are weapons of mass destruction” (Berkshire Hathaway Annual Report 2002) has been over generalized by the media. Derivatives are merely tools, as are other financial instruments, that when used properly can offer an effective offset to an exposure to other risks, i.e. foreign exchange, interest rate, or commodity prices, for example. While there is no question that derivatives offer a vehicle to speculate on a highly leveraged basis, that is not their primary use in  hedging, which is to reduce risk. Not managing one’s risks, and, therefore, the choice to float with market prices, is speculation whether it is by choice or naivety. This is not to say, that all risks need to be hedged and/or that derivatives are the only vehicle for managing such risks – the choice to hedge and with what comes down to ones risk appetite / risk capacity and other available alternative instruments / strategies. Contrary to the popular media, derivatives did not kill Wall Street during the financial crisis of 2008, unbridled speculation, combined with significant leverage, was a primary, but not only, weapon

Misconception about Hedging #6: Hedging Requires Crunching

Numbers. Though some number-crunching may be involved (one needs to quantify their exposures and analyze various risk scenarios), it is often overlooked that effective risk management requires more communication than calculation. From understanding a firm’s exposure, to determining its risk appetite and risk capacity (the ability to absorb such risks), to gaining buy-in from senior management and establishing clear objectives, it’s more important to spend the time communicating on both a pre- and post-hedging basis up, down and across an organization. You need buy-in from executive management and related staff to execute your strategy and prevent Monday-morning quarterbacking. Lack of communication, therefore, leads to misunderstanding of risk management activities, which can lead to the worst pitfall of all: Inaction.

Content by David Stowe

Craig Jeffery

Managing Partner
Craig Jeffery formed Strategic Treasurer in 2004 to provide corporate, educational, and government entities direct access to comprehensive and current assistance with their treasury and financial process needs. His 25+ years of financial and treasury experience as a practitioner, banker and as a consultant have uniquely qualified him to help organizations craft realistic goals and achieve significant benefits quickly. He is responsible for overall relationship management and ensuring total client satisfaction on all projects