I was reading an interesting blog by
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“When I was a young corporate treasurer I lost a fortune on a hedge but obviously the commercial flow balanced it. However the board noticed the losses I made so they asked me to explain why I could loose so much money. I was puzzled since I only followed the policy I had proposed and they had approved. I prepared a presentation explaining the policy with an example. A board member commented: ‘We understand the principles of hedging but we are anyway surprised that you did hedge since you lost so much money. Was that really necessary?’ I was chocked! What a question, we must be consistent in our hedging otherwise we would be speculating.”
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Totally agree. We are trying to mitigate risk and not doing any speculation here. But let’s still analyze this scenario and see if it could have avoided any apprehensions from the board.
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First: The very first and the most important step in any Hedging Strategy is to define its Objective. Objective should be clear and quantifiable.
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For example, Hedging Objective for an airlines company wanting to hedge fuel cost exposure could be ‘Not to spend more than 30% of revenue on fuel costs’. If in the above case, objective was quantified and approved as straight as this, probably, board would not have had apprehensions on any hedging losses, as long as the stated and approved objective was met.
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Second: The next important step is to quantify how much of the exposure is to be hedged. Inputs for this would be a forecast of volatility of the object being hedged with scenario analysis for perceived extreme conditions, such that costs do not exceed the stated objective even under extreme upside price movements.
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Now, while Objective (outcome of the first step) could be fairly static, the outcome for second step (how much to hedge), could be more actively managed. That is, any changes to the perceived volatility down the road could be reflected with changes in how much we are hedging. If this is done, our hedging gains will insure costs being under stated limits (as prescribed in the Objective) and hedging losses will be minimized (as we are not necessarily hedging the entire exposure). And likely, not have to explain hedging losses to the board.
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Let me explain this with a simplified example.
- Let’s say, our Air Line Company will use 100 barrels of fuel for the period and has decided to spend no more than $8,000 as fuel costs. This becomes our stated objective.
- Current spot price of oil is $50 per barrel.
- Forecast upside volatility is 100%. That is we expect oil could to go up to $100 per barrel in that period.
- For simplicity, we will assume we could buy futures at $50 per barrel for hedging and will ignore any transaction costs. We get exposure %age to be hedged as 40%.
- So, we have hedged 40 barrels of oil at $50 and have left remaining 60 barrels exposed to price fluctuations.
- Worst case scenario would be when we have to buy remaining 60 barrels at extreme upside price $100 per barrel. So, in this case, our total cost of fuel would be (40 barrels * $50) + (60 barrels * $100) = $8,000. Which meets our stated objective.
- In another scenario, where instead of prices rising, they fell to say $20 a barrel. In that case, out total cost of fuel would be (40 barrels * $50) + (60 barrels * $20) = $3,200. Hedging losses are $1,200. But understand that had we hedged our total exposure, our hedging losses would have been $3,000!!
In both cases, our costs are at or below stated objectives. And while meeting those objectives, we have been able to minimize our hedging losses.
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To summarize, the key is to Actively Manage, 'how much amount is to be hedged', with changing volatility prospects, while continuing to meet stated Hedge Objectives. If we increase the amount under Hedge Management to more than what is required, we would increase our hedge gains if price movement is upwards; But this will be at the cost of higher hedge losses, if prices move downwards.
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