Deciding to hedge or not starts with recognition of some exposure facing the organization. For instance, companies with debt bear interest rate risk, those that operate internationally bear foreign exchange rate risk, and those that buy or sell basic commodities bear commodity price risk.
Every enterprise faces some or all of these kinds of price risks, but not all companies elect to manage them. Critically, there’s a difference between electing not to hedge, as opposed to not hedging by default. The former course might be fully justified and understandable; the latter course, on the other hand, seems to be an abrogation of fiduciary responsibility.
After identifying one or more of the above price exposures the proper managerial process should be to determine the desired degree of exposure to maintain, with any residual exposure becoming a candidate for hedging. Simple in concept, but not so simple in practice.
One of the first issues that must be confronted in this process is the hedge horizon. Should we think about managing exposures that we expect to bear during the next year, next three years, next five years, or what? Clearly, there is no unique, correct answer. Different firms will make different determinations. But whatever the horizon chosen, risk lurks beyond that horizon. Put another way, we can only expect a hedging program to mitigate the effects of adverse price moves through the term of the hedge. Ultimately, after the term of the hedge horizon, the company would again be subject to market conditions.
A pragmatic response to this structural problem is to revisit the question of whether or not to hedge on a periodic basis. Irrespective of the stipulated duration, this discipline will foster a process that serves to phase in hedges over time. Importantly, companies should only hedge exposures that are expected to be realized with some reasonably high confidence interval. They certainly do not want to find that they have locked in prices relating to exposures that never are realized. And more likely than not, the longer the hedge horizon, the lower the confidence we are likely to have that the forecasted exposure will, in fact, materialize. It is one thing to project financing needs, say, in the next 12 to 18 months. It’s quite another thing to forecast those requirements 15 years out.
Worst case scenario
The nightmare scenario would be one where a company implements a hedge for a forecasted exposure, generates losses on that hedging derivative, and then finds that the exposure never arises. In such cases the hedge losses would stand alone, rather than offsetting any bona fide risk. On the other hand, if the risk materializes without being hedged and an adverse price move develops, the company would also suffer. Which is worse? Unfortunately we’re stuck not knowing until it is too late.
Part of the calculus underlying the determination of the hedge horizon may be what your peers or competitors are doing. Suppose your company hedges against adverse price changes, and your competitors do not. Obviously, your company would have the comparative advantage if the adverse price change arises, but if it prices move beneficially, your competitor would likely outperform (all else being equal).
Your competitors are not likely to be fully transparent about their risk policies, but at least some information should be reflected by their disclosures, as companies are now required to disclose on a quarterly basis when their derivatives are maturing. The longest dated derivative thus might reasonably be a clue to that company’s operating horizon underlying their risk management decisions. In assessing this information, though, it is important to realize that disclosures reflect past decisions, and if the reporting company is operating prudently, these positions will be adjusted periodically.
In any case, the fun begins once length of the risk management horizon is determined. Whether or not to hedge a particular coming exposure within that time frame would depend on finding either that the un-hedged position leaves an unacceptably large probability for a reduced profits (or losses) due to an adverse price move, or the prevailing pricing of derivative contracts allows for locking in an attractive—or, at least acceptable—price.
The amount of the exposure to hedge, again, is a matter of judgment. To a certain extent, entering into a hedge is a pricing decision. Hedging now would be most appropriate if you thought that the current opportunity (i.e., current derivatives pricing) was the best it would likely be before the critical exposure date. Waiting—or, perhaps never hedging—would be best if you thought that better terms would likely be available later. The lack of certainty with regard to this issue would seem to be an argument that favors hedging at least some portion of the expected exposure(s).
So how should management proceed in the face of this unavoidable uncertainty? Again, there is no universally right answer, but in any case, it should be thought of as a process, as opposed to a trade. As time passes, new market information becomes available; and this new information should influence management’s sensibilities about its forecasts in connection with both the magnitudes of future exposures, and their associated prices. With changing perceptions about these considerations, hedge positions should be adjusted, accordingly.
One complicating factor is that longer-dated derivatives are often not as readily available as shorter-dated derivatives—or, if they are available, bid-ask spreads for these longer-dated contracts may be exaggerated (i.e., more costly) relative to their shorter-dated counterparts. In such circumstances, the hedger might consider using a series of shorter dated derivatives.
Do not expect this “rolling hedge” strategy to be perfect. That is, the price of the replacement derivative will likely differ from the price of the expiring derivative, and this differential will thus foster either a cost or benefit, depending on which is being purchased and which is being sold. A look at history might help in estimating the likely magnitudes of these price differences, but prices pertaining to coming roll-overs won’t necessarily be similarly these past price differentials. It may be a case, however, that it comes down to using this kind of roll-over strategy, or nothing.
All hedging decisions involve trade-offs. The ideal would be to fully hedge at the onset of prices moving adversely and to remain fully unhedged when prices were poised to move beneficially—but that ain’t gonna happen.
This reality makes the notion of a “right” or “wrong” decision a matter of judgment. The right decision is one that appropriately balances the tradeoffs. Whether it turns out to be profitable or not is something that can never be known, with certainty, at the decision point. Often, that uncertainty becomes paralyzing, fostering the outcome of remaining fully unhedged by default.
That persistent state is not right or wrong—it’s just bad management.