Chapter 24
Musings About Hedging
This chapter is personal.
I've had the good fortune to be able to enjoy a career in finance for more than 25 years and counting. For almost all of that time, I've worked with derivative contracts of one form or another. My focus during the first half of my professional life was on exchange-traded derivatives. As the director of the New York office of the Chicago Mercantile Exchange (CME), I marketed the CME's financial contracts, including futures and options pertaining to interest rates, currencies, and equity markets. Since then, my scope has broadened to include over-the-counter derivatives as well. For the most part, however, I've stayed with pretty traditional tools: futures, forwards, options, and swaps—plain-vanilla derivatives and textbook applications.
At the end of 1998, the CME closed its New York office, and I started consulting. A niche had developed that turned out to work for me. Just about that time, the Financial Accounting Standards Board (FASB) had come out with new accounting rules for derivatives and hedging transactions. The rules were (and still are) complex and difficult to apply. The FASB appreciated this problem and recognized that questions were bound to come up. To assist in responding to these questions, the FASB established a Derivatives Implementation Group, which was tasked with advising the FASB on implementation questions being submitted by the public. I was invited to be a member of this group and, with this credential, my consulting tilted toward assisting companies with these concerns.
Shortly after leaving the CME, I also started trading futures and options for myself—something that was prohibited while I was an exchange employee. After establishing a track record, I founded the Kawaller Fund, structured as a commodity pool, and offered my services as a money manager.
I've come to appreciate that many lessons that are commonly understood and accepted by one market segment get overlooked by other market segments. Put another way, hedgers tend to see the world one way, traders see it somewhat differently, and accountants see it yet another way. The perspectives of each, however, are deserving of consideration by the others. That's what this chapter is about.
THE HEDGING ORIENTATION
Hedgers are subject to some preexisting risk, and they use derivatives as overlay positions to mitigate this risk. In my experience, most companies fail to use derivatives to their maximum advantage. The vast majority of companies tend to rely on one tool for each exposure. For instance, most companies that hedge variable interest rate debt rely exclusively on interest rate swaps for their hedging purposes. This strategy has merit, of course, but so do other strategies; and these other strategies warrant consideration, as well.
As an example, from time to time, companies may find it advantageous to use caps to provide one-sided protection against the prospect of higher variable interest rates, leaving the prospect of being able to enjoy the benefit of lower rates, should they occur. Alternatively, they might consider using collars or corridors instead of swaps.1 Making the selection of one strategy without consideration of other alternatives is simply shortsighted. If these alternatives are categorically ignored, the potential opportunities that might otherwise be achieved would be lost.
A single-minded approach to hedging isn't unique to interest rate hedgers. In almost any market sector—pertaining to interest rates, currencies, or commodity prices—companies tend to rely on a single risk management tool with a single associated hedging objective. Different times and different conditions (i.e., different price relationships) would likely change the balance of preference for one tool over another, but you have to evaluate relative costs and benefits on an ongoing basis to be able to capitalize on opportunities when they arise.
Beyond the determination of the preferred hedging objective (and thus the appropriate derivative construction), the question of how much to hedge is often approached suboptimally. I favor imposing a systematic procedure that sets a specific planning horizon and ranges of hedge coverage within that horizon. For instance, consider the company with an ongoing need to buy euro-denominated goods. The company might operate with a three-year planning horizon, where its policy stipulates hedging 50 to 70 percent of the prospective euro-denominated purchases expected to occur in the first year, 30 to 50 percent of the second year's exposures, and 10 to 30 percent of the third year's exposures. The hedge positions would likely be adjusted higher as time goes by, all else remaining equal. This approach still affords considerable discretion to the hedge manager; but at the same time, it ensures that at least some risk mitigation will occur.
Presumably, the appeal of the declining coverage for the further exposures derives from the greater uncertainty for the more distant events. Any comments to the contrary notwithstanding, hedgers will likely be predisposed to hedging more of their exposures when their fear of an adverse market move is more pressing, and vice versa. Moreover, we tend to have a greater confidence in our capacity to forecast near-term versus long-term.
While this approach is common to foreign exchange (forex) hedgers, it tends not to be used for variable interest rate exposures. That surprises me. If the concept has appeal, why wouldn't it be applied more broadly? Beats me. The parallel hedge treatment in the context of most interest rate risk might call for applying amortizing swaps (i.e., swaps with declining notional amounts over their terms) to variable interest rate exposures; but this rarely happens. Amortizing swaps tend to be used in conjunction with amortizing principal amounts on exposures, or not at all.2
This determination of how much to hedge deserves ongoing consideration. Hedging is a process. It's not a trade. Thus, the prudent approach should track the net exposure (i.e., the unhedged portion of the company's risk) and modify the hedge coverage if and when this net exposure falls outside of an acceptable range. All too often these subsequent adjustments to the hedge position aren't considered in any sort of disciplined way.
Suppose you've put on a hedge—any market, any hedging construction—and further suppose that subsequent to putting on this hedge, the risk being hedged starts to be realized. In response to these market conditions, the hedge gains in value. Now what? Should the hedge be terminated or continued? Although there's no right answer here, the resolution should be well considered—not ad hoc. Understand that if the hedge were terminated, on the one hand, the hedge gains would, of course, be captured; but we'd no longer be protected from further adverse market moves. On the other hand, if the hedge position was maintained and the underlying price trend reversed direction, we'd necessarily have to give up the previously generated hedge gains. Clearly, our course of action should be to reflect our best judgment about the future. There's no getting around that. The only wrong response would be to ignore the situation and blindly proceed without reconsidering how much hedge coverage should be maintained.
Some companies have no regularly scheduled assessments of hedge coverage. Even so, they may (or may not) react to some precipitous market move or to some significant structural change in their organization. With such a development, they wake up to the fact that their net exposure is out of kilter and something needs to be done. A better approach would be to operate with regularly scheduled reviews, augmented by more episodic considerations in response to changes in the economic landscape.
So how frequently should these reassessments be done? Annually, quarterly, monthly, weekly, daily, hourly? I tend to believe they should be more frequent than the reporting interval, but I have no bias favoring any particular horizon length for this purpose. That said, my suspicion is that few hedgers would opt for hourly or daily reviews. Somehow, that frequency would seem to move us from our perch as hedgers into the world of traders. With especially frequent reassessments, it's unlikely that the aggregate gains or losses of a hedge over time will correspond to the gains or losses on the exposure over virtually any accounting horizon. This outcome might not necessarily be a bad thing, however.
Suppose the hedger imposed a hedge to protect against rising prices just before these prices moved sharply higher. Then, with prices at or around their peak and the perceived threat of further price increases no longer pressing, assume the hedger now terminates his or her derivative position. Clearly, if prices retrace their rise, returning to their original level, this hedger would capture the gains on the hedge with no corresponding change in the price of the hedged item. To my mind, this example is illustrative of one of the more attractive scenarios under the myriad of possible ex post hedge outcomes. The fact that the hedge gains don't correspond to losses for the hedged item doesn't bother me a bit.
Before moving onto the next section, I have one heretical point to make about hedging: With every application of a derivative contract, at the inception of the hedge, it's not clear that the hedge will gain or lose. Clearly, though, hedgers would have to expect the derivative to make money or else it would be unlikely that the hedge would be transacted in the first place. Put another way, we tend to put on hedges when we perceive the adverse price move to be more likely. It's all well and good to claim that, as a hedger, we don't care about whether the hedge makes or loses because the exposure would be generating the opposite effect, but it's hard to imagine a company entering into hedges with the expectation that these hedges will generate losses.
The question of expected gains or losses aside, we might still favor hedging because we expect it to foster lower income volatility, which we might expect to work to the benefit of our company's valuation. (Investors tend to reward companies with lower income volatility with higher price-earnings [P/E] ratios, all else remaining equal.) Thus, we might be prepared to lose some money in the short run. In the long run, however, it's not clear that this is an appropriate trade-off to make if the cost of attaining lower income volatility is reduced expected earnings.
This concern is especially vexing because, in the general case, hedges tend to cover only part of their exposures. Thus, in terms of the bottom line of the company's performance, the company is actually better off making losses on its hedging derivatives, as that would mean even greater gains on the (larger) exposure. We find ourselves in the awkward position of putting on derivative positions and then hoping that they generate losses. Weird.
THE TRADING ORIENTATION
Although there may be about as many trading styles as there are traders, I'd expect the vast majority of professional traders to agree on the following points (in no particular order):
- Financial market prices (and hence derivatives prices) exhibit considerable random variability.
- You can't reliably pick market tops and bottoms.
- To be successful, you have to limit losses—which are inevitable for active traders.
- All price projections deserve skepticism, but the degree of skepticism should rise with the length of the forecast horizon. (We can be more confident of near-term forecasts than we can be of longer-term forecasts.)
These four points should influence the way hedgers behave. For instance, given the decision to enter into or exit from a hedge, phasing into hedge positions rather than effecting a single transaction may be an appealing tactic. This point is especially compelling when you appreciate the typical way in which companies size their hedge portions in the first place. Except in rare circumstances, hedging need not be—and in my judgment, should not be—an all-or-nothing proposition. In the general case, when an exposure looms, most companies will decide to hedge only a portion of the exposure, rather than all of it.
In making this decision, it's useful to realize that the portion of the exposure that the entity chooses to hedge is revealing. It says something about the hedging entity's market view. Consider the foreign currency hedger exposed to the risk of a stronger foreign currency. The use of a forward contract locks up the exchange rate for some future value date. In effect, entering into this contract today (as opposed to leaving the exposure unhedged) is a bet that the exchange rate will move adversely, from today. Leaving the exposure unhedged, in contrast, is a bet that the prospective exchange rate change (by the value date) will be beneficial. The term hedge is somewhat of a misnomer in this instance. Fifty-fifty coverage, meaning 50 percent of the exposure is hedged and 50 percent of the exposure is left unhedged, is the only hedge position that reflects a neutral or agnostic view of the course of exchange rates. Does that mean that this 50–50 hedge ratio should be instituted? Not necessarily. Business judgments should be able to override, but decision makers should understand when they are taking a market view and be held responsible for deviating from the neutral standard.
A possible exception may arise in connection with companies that use derivatives to effect a spread—such as a financial intermediary that seeks to lock in a net interest margin or a commodity distributor that buys product from a supplier and sells it to a customer. In these cases, the enterprise may be largely immune to sharp changes in interest rates or commodity prices, as both revenues and expenses respond similarly to the underlying interest rate or price change. Thus, the hedges are designed to compensate for timing imbalances. Even in such situations, though, it's a rare company that operates on a fully-hedged basis. The more typical case is one where some exposure remains.
In any case, most hedgers come to the determination of how much to hedge fairly casually. Put another way, the hedge coverage is usually determined without a great deal of rigor. Usually, some fairly arbitrary portion of the exposure is selected as the amount to be hedged. For example, the person/committee tasked with the responsibility of sizing the hedge picks 50 percent for the exposure, rather than 40 percent or 60 percent. The decision is hardly the stuff of higher mathematics. It simply comes down to a business decision.
How much we hedge, though, should likely be influenced by the pricing of these derivatives, but this consideration is too frequently overlooked. Again, returning to the forex hedger considering the use of forward contracts to lock up exchange rates on prospective purchases, wouldn't it make sense to employ a process that covers some minimal portion of the exposure at the start, but where there are standing orders to add to the hedge coverage if and when opportunities arise to lock in even more attractive exchange rates?
This approach can be applied in the reverse direction if the exchange rate starts to move beneficially, as well. Notice that this adjustment process would result in buying cheap forwards and selling expensive forwards. Thus, if exchange rates fluctuated within a trading range, our practice would end up generating incremental trading gains. As always, the ever-present risk is that anything not hedged is exposed. Thus, whatever trading rule we might be tempted to apply, the original question of how much to hedge needs to be readdressed on some periodic basis, independently from any technical (i.e., trading-determined) adjustments that we might otherwise be making.
THE ACCOUNTING ORIENTATION
When it comes to derivatives accounting, it is critical to differentiate between two environments: the trading environment versus the corporate finance environment.
In a trading environment, the entity assembles a portfolio of instruments (including derivatives), and the objective is simply to generate gains through any combination of interest income, dividends, and capital gains. Here, accounting for derivatives is a trivial exercise. Derivatives are carried on the balance sheet at their market values, and gains or losses are recorded in current earnings.
It's much more complicated in a non-trading, corporate finance environment. Here, the concept of special hedge accounting is of particular relevance. For hedgers in this environment, it is logical and desirable to record the earnings impacts of derivatives concurrently with the earnings impacts of the hedged items. For instance, if a swap is being used to hedge prospective variable interest rate exposures, it's quite understandable that the hedger would want the swap's current period settlements to impact current earnings—but nothing else. That is, with the sacrosanct requirement to carry the swap on the balance sheet at its fair market value, this type of hedger would prefer not to record the change in present value of the swap in current earnings. The hedger would want this component of results to be deferred.3 Unfortunately, while this desired accounting treatment may be available, it can't be counted upon. Special hedge accounting would preserve this pairing of the derivatives’ earnings impacts with those of the hedged items, but this treatment requires specifically crafted hedge documentation, and the qualifying criteria are often difficult to satisfy. Even if these criteria are satisfied when hedging is initiated, in many cases the authority to apply hedge accounting could be terminated midway through the hedge.
It is often said that Financial Accounting Standard No. 133 (FAS 133)—the governing rules for accounting for derivatives and hedge accounting, which has since been recodified as Accounting Standard Codification (ASC) 815—is “form driven,” meaning that if the documentation isn't correctly presented, that fact by itself could disallow hedge accounting. Hedgers need to appreciate that their documentation will detail much of the qualifying criteria to enable the application of hedge accounting, and they will be held to these requirements. History is replete with examples of companies specifying conditions in their documentation that they've then been unable to satisfy—often for seemingly trivial or stylistic reasons—thereby precluding the use of hedge accounting. Whether you handle this responsibility in-house or with a consultant, this responsibility needs to be in the hands of someone with specialized knowledge and experience. Too many pitfalls lie in waiting, and the consequence of getting caught could be severe.
Without hedge accounting, unrealized future gains or losses for all prospective periods in the hedging horizon will be recorded in current income. For example, for the variable interest rate hedger with, say, a swap having five years of remaining life, if interest rates change, the current earnings effect will include not just the most immediate settlement amount, but also gains or losses relating to all future settlements. In effect, if no hedge is in place, the company will realize income volatility relating to just the current period. With a hedge in place but without hedge accounting, the current period's income volatility could be many times higher.
This situation creates a dilemma for the hedge manager. If hedge accounting is tenuous, a question arises as to whether to (1) put a derivative position in place and take the risk of (substantially) higher income volatility if hedge accounting can't be applied or (2) remain unhedged, where income volatility might reasonably be expected to be less severe. All else remaining equal, those entities at risk of losing the authority to apply hedge accounting will be discouraged from hedging, and some might fail to implement prudent long-run risk management strategies in deference to this short-term consideration.
To be fair, the reader should appreciate that, as of this writing, the Financial Accounting Standards Board (i.e., the entity responsible for promulgating accounting rules) is evaluating the current accounting rules for derivatives, and changes are being considered. Philosophically, the proposed new rules would seem to be tilting toward lowering the bar in terms of hedge accounting prerequisites. That said, the devil is in the details, and I'm not at all convinced that the end results of this process will necessarily make (and keep) hedge accounting more accessible. This issue is one that deserves an ongoing watchful eye.
There is one area under the accounting rules, however, that is especially problematic and is likely to remain that way. Specifically, I'm referring to interest rate hedging where the hedged item is fixed-rate debt. Here's the problem: There are two major types of hedge accounting: cash flow hedge accounting and fair value hedge accounting. Cash flow hedge accounting applies to exposures associated with future, uncertain cash flows. Thus, by default, any exposure to fixed interest payments cannot apply cash flow hedge accounting. The only avenue available for such exposures is fair value hedge accounting.
Fair value hedge accounting requires the derivative's gain or loss to be recorded in current earnings, but so, too, is the gain or loss of the hedged item, due to the risk being hedged. A prerequisite for qualifying for this treatment is making the statement that the derivative's result is expected to (closely) offset the change in the fair value of the hedged item (i.e., the fixed-rate debt), due to the risk being hedged. The problem is that for the classic interest rate objective of swapping from fixed to floating, this outcome should not be expected.
Consider the case of a company that simultaneously issues five-year fixed-rate debt at par and simultaneously enters into a five-year pay floating/receive fixed swap. Assuming that the notional amount of the swap matches the principal on the debt, and the swap's accrual periods are aligned with the debt's accrual periods, this swap will perfectly serve to replace fixed interest payments with variable payments based on the variable index of the swap. There's virtually no chance, however, that the gains or losses on this swap will offset the change in the fair value of the debt. Remember, over the life of the debt, the change in the fair value will be zero, but the gain or loss on the swap will be the sum of the cash flows paid or received over the life of the swap. Although we don't know what this swap gain or loss will be, we can be sure it will be something other than zero!
This isn't to say that companies aren't managing to qualify for and apply fair value hedge accounting in these situations. They are—but with great difficulty. And in fact, unless or until the FASB authorizes a significant overhaul of fair value hedging rules, it's likely that this problem will persist.
CONCLUSION
Typically, managers learn about hedging one instrument at a time. They start with their predominant risk category (e.g., interest rate risk, currency exchange rate risk, or commodity price risk), and then they identify the derivative of choice and learn how to use it. The textbook application is conceptually quite simple: Determine the amount to be hedged, and enter into a derivative with the derivative position sized to compensate for this magnitude of exposure.
This chapter strives to move to a higher step on the learning curve. It intends to highlight the fact that hedging is—or should be—a dynamic process. It recommends that hedgers review their exposures and hedges periodically and adjust their positions in type and size as market conditions vary and risk appetites evolve. It further looks to the experience of traders as a source of knowledge and experience that could be relevant in connection with tactical aspects of how hedge positions are transacted. And finally, the chapter warns that hedgers need to be fully cognizant of how their hedge positions will impact reported earnings. Unfortunately, the current accounting regime may serve to discourage hedgers from pursuing prudent risk management goals due to considerations relating to the timing of income recognition.
NOTES
1. In this context, a collar would be constructed by buying a cap and selling a floor, thereby imposing a best-case outcome and a worst-case outcome for interest expenses. A corridor involves buying a lower-strike cap and selling a higher-strike cap. This combination locks in the interest expense if the market interest rate falls between the two respective strike yields, leaving the company exposed beneficially to market interest rates below the lower strike, and exposed adversely to market rates above the upper strike.
2. It may be cumbersome to make incremental adjustments to the hedge coverage with swaps. Eurodollar futures/options, however, could serve quite conveniently for this purpose.
3. Changes in the present value of the swap are ephemeral (i.e., swaps typically have a zero present value at inception and at termination). Put another way, ex post, gains or losses of swaps held to term are equal to the sum of the settlements. Any gains or losses from sources other than the swap's settlements will necessarily have to be netted out over the life of the swap.
ABOUT THE AUTHOR
Ira Kawaller: Prior to founding the Kawaller Fund and Kawaller & Company—the former being a commodity pool and the latter being a consulting company that assists companies in their use of derivatives—Kawaller held positions with the Chicago Mercantile Exchange, J. Aron & Company, AT&T, and the Board of Governors of the Federal Reserve System. He received a PhD in economics from Purdue University and has held adjunct professorships at Columbia University and the Polytechnic Institute of New York University. He is currently a board member of Hatteras Financial, a publicly traded real estate investment trust (REIT); and he has also served on a variety of professional boards and committees, including the board of the International Association of Financial Engineers and the Financial Accounting Standards Board's Derivatives Implementation Group.