## Sunday, June 28, 2009

### Hedging using derivatives

There is a fascinating article in The Economist about how the world of derivatives has shaped up through the crisis.

I often encounter misconceptions about hedging. The one line that summarises the issue is this: The job of a hedging strategy is to combat extraneous economic exposure. Let me focus on currency exposure as an example, though the basic idea works in all aspects of hedging. A good currency hedge is one which neutralises the effect of currency fluctuations on the NPV of profit.

I have seen four major mistakes in the way people think about hedging:

1. Hedging seen as a way of eliminating currency risk in the translation of direct import/export proceeds. This is wrong because it's an incomplete picture of what happens to the profits of a company when the currency moves. A lot of finance practitioners are confused on this subject, particularly in India where RBI rules have had mistakes on these things for decades. (While RBI staff made mistakes, that was no reason for currency hedging consultants and such like to also make the same mistakes).
2. Hedging seen as a profit centre. This is wrong because the job of hedging is to eliminate exposure of the NPV of profit, not to make money. Suppose a company embarks on a currency hedging program. Half the time (ex-post) the hedge will appear to have made money and half the time (ex-post) the hedge will appear to have lost money. For a company which has very big currency exposure, ex-post, half the time there will be massive cash losses on the currency hedge. If top managers, directors or regulators do not understand this correctly, it's easy to jump into complaints about massive losses on derivatives trading'. This emphasises the importance of seeing a hedging strategy and the economic exposure in an encompassing way. A person who closes out one element of an overall hedging strategy because that's generated a lot of cash outflow in recent days is, well, wrong.
3. Hedging away the core sources of profit. A refinery is a bet on the crack spread', the gap between the price of crude oil and the price of petroleum products. The shareholder and owners of a refinery are inexorably speculators on the crack spread. If you don't believe that this spread will do well, don't build a refinery. For a refinery, this is core business risk, this is the source of profit. It is not an extraneous economic exposure. To try to hedge away this exposure is not correct.
4. Insecurities about imperfect hedges. Every now and then, a bright person complains that a proposed hedge has a substantial basis risk. The only perfect hedge is found in a Japanese garden. All realworld hedges are imperfect. The useful question is: Is an imperfect hedge better than no hedging?

The Economist article points out that with the upsurge in volatility, demand for derivatives has gone up, not down. Once most large firms of the world start doing balance-sheet scale hedging, derivatives positions will be much larger than they are today. The world needs bigger, not smaller, derivatives markets. We stumbled on our way to that world, and now have to figure out once again how we are going to get there.

In the world of OTC derivatives, firms face credit risk owing to contracts with banks and banks face credit risk owing to contracts with firms. In the good old days, these risks were mostly ignored, and OTC derivatives looked more attractive than exchange-traded derivatives (where posting collateral is unavoidable). Now, both sides are getting wary about what this involves. Banks have started charging higher prices for bearing this risk (either though a bigger price or through collateral requirement), and banks have started refusing to have exposures against certain firms. Both these phenomena should enlarge the footprint of exchange traded derivatives. All this flows logically but it was interesting seeing descriptions in the article about things actually shaping up this way.

#### 5 comments:

1. Hi Ajay,

One can have passive hedging or active hedging. In active hedging one can try to make money and save hedging cost.

2. I agree with the theme of the blog and I have the following points to make
1) It is generally media including financial papers that make huge uproar over derivative losses without knowing that whether it was a speculative trade or an offset hedge.
2) Govt. itself seems to be confused on derivatives front. Consider a case of a corporate that has used derivatives as a hedging instrument but everything goes for a toss as Govt. has banned futures.
3) Besides this corporate lack conceptual knowledge about hedging and therefore blame others for selling exotic derivative products. This deficiency is projected as if hedging is bad.
4) There is no market depth; Indian commodities markets look hollow when one wants to hedge 6-months exposure. At the most two month contracts are liquid that too in a very few commodities.

On comment by Santosh,

One employs a hedge only if it is feasible considering the cost of hedging. If cost of hedging itself is greater than price risk; better take a subjective call.
I think there are no free lunches out there, one would be exposed to additional risk in so called "active hedging". Anything you do other than hedging dilutes the objective of hedging. I would say that is speculation.

3. Another aspect that can be looked into especially with ref to indian corporates is the way coverage is being measured and how the derivatives taken especially options being managed. In lots of cases, corporates into derivatives don't have the requisite skill set and thus several times we have notional opportunities driving the derivative trading rather than economic exposure management. Apart from that cost reduction strategies create possibilities of extending losses cause we end up with multiple positions where though the cost has been reduced but the open exposures could be very high and way different from the exposure being hedged

4. Agree with some comments in the Blog. Practically the banks with their treasury desk on whom the industry relies more are also not equiped enough or doesn't advise the clients proactively when the situation is about to reverse.Once the heging tool becomes a nightmare for some industries. It may even lead to an eventual cause of die-out for some. Still today in the onshore market to cover up old contract or roll over past position bankers are active.Either they may be enjoying profit if they are the counter party to contract or doesn't have skills to suggest taking forward and loing the equivalent premium which is much more better than what in past someone has entered at 40 or 42 thinking it will go to 35. AS11 implementation will lead to disclosure of such many.

5. Dear Sir,
Please share your thoughts on
"Hedging away the core source of profit"
I believe that feasibility of refinery business is not only related to current 'crack spread' but it is also a function of at what rate/time you are buying the raw material and selling the products as back to back buying selling is not practical. Consider the following cases
Case1: Crude inventory is built at a particular level and then the price corrects lower. In this case even though the crack margin may be positive the loss due to high raw material price may make transaction infeasible.
Case2: Products are sold through forward contracts and the crude price goes up at the time of raw material procurement.

I think these factors should get equal consideration while determining the feasibility of refining/processing business.

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