A Primer on Hedging | Value Research The objective of such investment is 'not' to maximise profits, but to reduce Risk
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A Primer on Hedging

The objective of such investment is 'not' to maximise profits, but to reduce Risk

An exporter 'has' to sell Dollars, an importer 'has' to buy Dollars. If you already have bought a particular stock, say Tata Steel, you are now at "risk" of the share going up or down. When it goes up, it is called return; the same for your export Dollars, and if the Dollar goes down, the same for your import Dollars. So Risk is the opposite of Return, like opposite sides of the same coin, while Volatility is the process of the coin spinning....

What is hedging?
The word comes from "hedge", which is to protect. It implies a kind of 'insurance'. Investopedia defines it as "the making of an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract."
The objective of such an investment is 'not' to maximise profits, but to reduce Risk. Since Risk follows Return, and hedging reduces Risk, hence increases the Risk-adjusted Return.
Given that our hedging techniques use volatility to beat the Cost of Capital, they increase Returns substantially, thereby having a dramatic impact on the company's profitability ratios.

In the example above, if you already have Dollars to sell, you could sell "out-of-the-money" Calls (options to buy Dollars). If the Dollar rises, you deliver your export receivables. You might have a loss compared to the market, but you have a profit compared to your "Budget", i.e. you have a higher realisation on your export Dollars than you would have if you had merely sold at a randomly determined spot price. If this is done regularly and systematically, it creates additional value.

The Dollar may not always rise though. If it falls, the option expires worthless and the exporter may have a profit on the Call options that he sold, but has a loss on the Dollars he was holding for future sale. The profit on the option mitigates his loss on the Dollars he now has to sell on the spot market.

The exporter may do similar things on the Futures market. He may sell Futures, and buy them back if the Dollar price drops. If it rises, he delivers the Futures contract on the expiry date. The sum total of his selling and buying back (a.k.a. trading Volatility) should be added to the average sales realisation he got from delivering on the contracts where the Dollar rose after he sold. If done skillfully, this can sometimes be more than the maximum Dollar realisation that is offered by the market. You would have to be God, to be able to guarantee that kind of Dollar realisation to any exporter. Yet, it is possible to get that kind of average Dollar realisation over the long-term.

How is hedging a kind of Insurance?
It is a kind of self-insurance, i.e. you do not have to buy insurance from an Insurance company, but you are doing your own self-insurance, very much like driving safely to avoid accidents and hence, damage to your car...
Like the principles of good driving, it reduces Risk to your business and improves your financial health. It forms part of the larger subject of Risk Management.
Most hedges are actually sellers of Insurance, while the buying is done by speculators. That is because hedging is done with leverage, i.e. through the Futures and Options markets. Both these markets give you inordinate leverage against an 'underlying', which attracts speculators. And since the leverage can only be unwound by the future delivery of the actual asset, that is available only to the Physical Business. Hence this peculiar distortion.
Another reason is that when you are selling options, you get a limited Option Premium in return for taking unlimited Risk; when you buy Options, you pay a limited sum (which is wholly at Risk), in return for an unlimited Return, just what speculators are looking for. Hedges looking to reduce Risk in their business, will tend to take the Option selling side, because there is an embedded extra Return in the Option Premia itself.

What if I don't do it?
Like any other example of bad driving, you can carry on, till you have an accident. It is no different from bad eating (habits). There are principles of good health (like some exercise, a daily walk, etc) which are always some effort, but they are good for you...
On the plus side, some bad eaters live long and some bad drivers do too (live long). But you do reduce the probability of dying early, through the principles of good driving.
Good hedges do not always do well, but mostly they do. Some hedging tools, under certain accidents, actually increase Risk, but mostly, they end up reducing Risk.

What are the benefits of hedging?
Either the Physical Business does well, or the Hedge Operation (often called the Treasury) does well, but both together always do better than any one of them alone. Like any other business, there are quality issues, i.e. there are sometimes bad business processes and bad hedging, just like bad driving. That does not negate all driving; it only cautions you against bad driving.
Insurance is the most profitable business in the world, over the long-term. It is the only business in the world, where you get 'money for nothing' (the Beatles also wanted the chicks for free); it exchanges "perceived Risk" for real Risk, i.e. if you think you are going to die next year, you may pay a certain Insurance Premium, but the actual payout by the Insurance company come when you really die. In the language of Derivatives, you earn on Implied Volatility, but you pay on Realised Volatility. The difference, in the language of Behavioural Economics, is an irrationality; in a perfect market, the two are supposed to be equal, but we know from experience that markets are horribly wrong over the long-term, and systematically so...
So a Physical Business that sells 'Insurance' to the speculators, should do well if it knows what it is doing....and that is the catch. Like all driving, hedging is usually good for you, provided you do it skillfully. Just as bad drivers blame the traffic (and not themselves), hedging gets a bad name because of poor skills rather than being intrinsically dangerous.
The cost of not hedging is usually the same as the cost of not driving, i.e. you walk. Businesses live with sub-normal returns, poor profitability and large unhedged risks, which can sometimes single-handedly destroy them; they remain pedestrian businesses, suffering from low market cap and a famine of capital, because they must 'walk', not drive....
Speculators belong to the financial markets. Mostly, financial markets supply capital to business through IPOs and equity placements; this is one way by which financial markets can contribute 'equity' through the P&L Account. Since this method uses limited capital, the returns from this 'business' look extra-ordinarily high, because there is 'Capital Charge', i.e. it shows up in the infinitesimally small expansion of the Balance Sheet, for a fully hedged Business. Most of the capital in this operation is off Balance Sheet... This is first in the series of articles on hedging.

The author teaches, trades and writes.

This column first appeared in October 2013 issue of Wealth Insight.

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