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A Primer on Hedging.....contd

Our second installment on hedging tells you about its dangers & how you can avoid falling into these traps

We will start this second part by first detailings the dangers of hedging and how companies tend to define their portfolios over long period of time.

Dangers of Hedging

The dangers of hedging are the same as the dangers of driving. As long as you are 'in control', i.e. your driving is moderate with reference to the kind of car, road and driving skills that you have, you are ok. If you do anything to excess, you are in danger.....in hedging, the excess is with reference to the business risk that you are seeking to manage.
For example, most hedgers define their portfolio as 1 year's (export) receivables/ payables, and draw up their hedging plans with reference to this portfolio size. However, impressed by the often outstanding profitability of some skilful (or lucky) hedging operations, companies tend to define their portfolios over longer periods of time, losing all link with the balance sheet that they are carrying. I have seen this happen at some Indian companies, especially in the commodity sectors.
In actual practice, I find that the leadership in such companies has no understanding of the link between hedging and speculation, or the difference between the two. This results in unrealistic expectations being built up, which invariably come to grief.
Companies sometimes confuse "natural hedges" with an absence of risk, thereby finding it unnecessary to manage these natural hedges. This is the most dangerous misconception of all, because it gives you the impression of apparent safety, pushing you to take on extraordinary risks.
The illusion of safety is particularly dangerous, because it prevents companies from even calculating the 'cost of doing nothing'. In many businesses, I have seen that profitability in an importing/ exporting business is historically volatile, but there is no attempt to even analyse why it is so. Even "naturally hedged" flows in large companies, (where the Fx balance is across businesses, i.e. one business is exporting, while the other is importing, but they have sharply different profitability), are never analysed to examine whether they are actually safe, and does the 'natural hedge' increase or decrease profitability. For example, you could be importing oil (or a downstream petrochemical) and exporting gases in a different business. Now your imports are inelastic and go into a low margin business, but your exports are highly profitable, but highly elastic to forex movements. So you think you have a natural hedge, but actually, your profitability is very sensitive to forex movements.

Static Vs Dynamic Hedging
Static hedging is when the hedger takes a 'view', i.e. he sells his dollars at a particular point, which he thinks is a 'good' price. This price is usually determined with reference to his business, and not with reference to the market. So if his cost of production is Dollar= Rs 50 (equivalent), he might find 55 a good price to sell, even if the actual price line subsequently shifts to 60. This kind of hedging is done by high value-added businesses, like auto components and fashion garments.
But if you are importing, or exporting (or worse, importing and exporting) low margin products like (say) paraffin wax, chemical solvents and plastic granules, you need to be sure that average import price of your inventory is in the lower percentile of the market movement in the dollar, otherwise you are out of business. For example, if you were 'lucky' enough to have imported 6 months' supply of plastic granules in April, 2013, you are doing roaring business. But if you are bringing in the stuff at Rs 63 to the dollar (including forward premium), you are probably selling at a loss.
To survive, you have to shift to 'dynamic hedging', i.e. 'capture volatility' to bring down your inventory cost a dollar equivalent 57, before you can eat. That means using statistically robust techniques to ensure that your daily selling and buying of dollars in the futures markets, gives you enough profits to subsidise the selling price of your finished product in the physical business. And this is the subject of a book, not a paragraph in a column!

When Does Hedging ADD to Risk?
Simple. When the resulting leverage that you take on, is far in excess of what is either prudent, or in proportion to the demands of your physical business. When the treasury guy's room is next to the promoter's, when he no longer reports to the CFO, when his tantrums (and his salary) takes most of the CEO's time and money, in that order...when the company is a hedge fund masquerading as a sugar/ steel/ textile/ housing or whatnot company.
You can't fully describe it, but you know it when you see it...

This column first appeared in Mutual Fund Insight, October 2013.