Hedging is more than going ‘long' or ‘short'

“Either you understand your risk or don't play the game.” — Arthur Ashe, tennis legend

There is an intriguing argument in both academic and industry circles on whether corporations should hedge or not. The overbearing question is: Does this exercise add value to shareholder wealth in the company? Is it an economic activity involving the treasury of the company? What are the costs, and do the benefits outweigh them?

With enterprises worldwide losing billions of dollars on derivatives, they are seen as evil, next only to the Devil himself. To what extent is this justified and is ‘devil in hedging' for real?

A case in hand: Not long ago, corporates in India began taking minor exposures in currency forwards, swaps and, sometimes, exotics such as embedded options (including barriers). As these structures began spewing money, the corporates increased their exposures to significant levels and, perhaps, to levels beyond their control. This frenzy attracted not just exporters and importers, but also other entities (with insignificant rupee loan exposures) who swapped their rupee loans to Swiss franc to benefit from the interest rate differential of 2-2.5 per cent. Their justifications were, “the Swiss franc has never breached the conversion rate of 1.1 against the dollar in 25 years” and “we were not required to make any upfront payments and so, there was no risk”. It all changed overnight.

Markets reacted sharply to the sub-prime debacle, along with the gargantuan movements in forex rates that resulted in bets going wrong. According to industry analysis in December 2008, corporates suffered loss of around Rs 32,000 crore.

Sometimes treasury managers are inclined not to hedge. Their reasoning: “why should we hedge when risks can be diversified in an efficient market?” Under this assumption, risk premium is solely determined by the covariance of asset return with market return. Moreover, assuming that “hedging will not adjust future cash flows”, they try to achieve the hedged price as the expected price.

Enough reasons for hedging

Although there have been instances of big players such as Barings, Merrill Lynch, Proctor & Gamble, Caterpillar and some Indian corporates losing money through derivative products, it does not imply they are detrimental to the enterprise's risk management. Rather, things took a difficult turn for these organisations because they lost control of their hedging objectives.

One reason companies attempt hedging price changes is that they are risks that are peripheral and unavoidable to the business and economic environment in which they operate.

Elements such as commodity prices, interest rates, foreign exchange rates are “stochastic” in nature, meaning they are “random variables”, which are not predictable. Though we have advanced statistical tools such as Monte-Carlo simulators to forecast these variables, they are not that reliable.

Importantly, hedging is in line with the preferences of the company's “stakeholders”.

Empirical evidences show some shareholders refuse anything risky while others have a more aggressive attitude to risk. Strangely though, both kinds envisage an appreciation in the enterprise value with two different outlooks on enterprise-wide risks.

Recent surveys show corporations trading derivative products achieve enhanced cash flows and appreciating value for shareholders. Ideally, entities should have a proper risk management framework to buffer financial statements from market vagaries.

One way of reducing exposure to random variables is to review the corporation's risk appetite and set down defined objectives for “hedging”. Any hedging policy must achieve a balance between uncertainty and the risk of opportunity loss. It is in the establishment of balance that we must consider the risk aversion and preferences of stakeholders.

Specialisation is key

Treasury activity is a highly specialised field; only those with expertise should be entrusted with dealings in financial and commodity instruments, including derivatives.

Half-baked knowledge always proves expensive. It is essential that companies keep their treasury personnel abreast with the latest developments in the world of derivatives and risk management practices.

All economic hedges aim to manage exposure risk (financial and commodity), that is, reduce potential loss from fluctuations in interest rates and prices. Hedge accounting is meant to offset the mark-to-market movement of the derivative in the profit and loss account. A fair value hedge is achieved either by marking-to-market an asset or liability that offsets the profit-and-loss movement of the derivative. For a cash-flow hedge, some of the derivative volatility is channelled into a separate component of the equity called the cash-flow hedge reserve.

The change in fair value of the derivative is recognised immediately as profit or loss. Hedge accounting requires a large amount of compliance, which involves documenting the hedge relationship and proving it is effective.

Role of third-party consultant

Identifying the payoff from the uncertainties and the risk of opportunity loss poses a problem of adverse selection. It is advisable for the corporate to appoint a third-party consultant for an unbiased view of the market to identify, evaluate and validate the company's risk management policies.

Hedging is not just about going “long” or “short” on a forward or futures contract. It is also not about scripting the term structure of a swap agreement… Hedging is about making the best possible decision, integrating the company's attitude towards risk and returns, systems, people and the preferences of the stakeholders.

(Chiragra Chakrabarty is Director, and Ankan Mondal is Manager, Deloitte in India. The views are personal.)