Sunday, November 30, 2008

Corporate Hedging: Answers to questions

A couple of posts ago, I presented six examples of risk hedging/ taking that I would like to take through my three bucket test - risk to pass through, risk to avoid/hedge and risk to exploit.
  1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense? Given that Southwest's core competence (see, I can speak like a corporate strategist) is running an airline (not forecasting fuel prices), that fuel prices are such a large portion of total costs, and Southwest has done this through high and low oil prices (and are thus not trying to time the oil market) , I think it makes sense.
  2. In the last two years, other airlines that had never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense? I am much more suspicious of this activity. The very fact that they are hedging only after oil prices have run up, suggests to me that there is an element of market timing here. Not surprisiingly, firms that do this end up with the worst of both worlds. They hedge against oil prices after they have run up and stop doing it after oil prices have gone down.
  3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense? I think this does, since investors in the firm would have a difficult time doing this on their own. The team also has information on the player's physical status that an investor would have no access to.
  4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea? This is plain dumb. Aracruz is a paper and pulp company. As an investor in the company, the last thing I want them to try and do is time exchange rate movements (and I would have said the same thing even if they had made money)
  5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense? I have always been skeptical about propreitary trading profits reported at investment banks, since I see little that they bring to the table as competitive advantages. They trade with each other, using the same information base and often the same traders (who move from bank to bank). I see no reason to believe that a trader at an investment bank (and the economists at the bank) have any special insight into the future direction of rates.
  6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think? I invest in gold mining stocks because I am optimistic about gold prices going up. If Barrick goes out and hedges against gold price movements in the future, it is undercutting my rationale for investing.
The bottom line, though, is that we should not judge any of these firms by the outcomes of their actions, but by whether their actions make sense. (Aracruz could have made hundreds of millions on its currency bets and Southwest is probably losing money, now that oil prices are declining)


Aswath Damodaran said...

Just a check to see if comments are coming through.

peterxyz said...

the counter to the Barrick Resources position is that mining companies based their decisions to construct/expand a mine on an economic analysis which includes a value on the output.
Hence there is an argument for some hedging (even via deep out of the money options?) to ensure that they are meeting some minimum hurdle price.
You can then argue what proportion of the output needs to be hedged, etc.
It may also be value-creating if it significantly lowers the likelihood of bankruptcy

Heshrulz said...

This argument is very similar to the diversification argument isn't it? If the investor is better at diversifying then its better left to the investor.

But I have a problem with this argument. Because one period of adverse rally in currency markets can even wipe a company out of the business. The assumption is that an investor would have also invested in companies that have benefitted positively from the same currency movement which offsets this company's loss or even bankruptcy.

Is that assumption true - as in is it reasonable to assume so?

Secondly even if the assumption is true, the management of the company which is adversely affected can't convince themselves of this reasoning. Their bonuses and incentives would go for a toss. Also they are answerable to the shareholders who may not have such a holistic view and may not have diversified their investements.

Heshrulz said...

Infact I have been asking myself this question for sometime - because I am in the business of providing hedging solutions to corporates in India.

I have been amazed that most companies' hedging decisions are based on market timing - like you have said, I have seen people have the worst of both the worlds. And they don't seem to learn at all.

The worst part is people ask me for views and my expectation of USD/INR in a year's time etc... I so wish I could tell them "I don't know" but they would end up going for a competitor who gives him what he wants. I have been going through a cognitive dissonance for sometime and you are not helping my cause at all by posting more questions on the same topic!!!

rsmohnot said...

I agree with your comment on prop traders at investment banks. But what about proprietary trading by hedge funds and principal investing by private equity firms? Are they the appropriate bodies to be exploiting these risks on behalf of their investors? That is of course supposed to be their core competence.

One problem I have with the diversification and hedging arguments is that often times investors don't understand diversification and hedging well enough. If they did, given the risk averseness of the average individual, most individuals working at publicly listed firms would want to short the equity of their firm or short the entire market to hedge their human capital investment. What about Steve Jobs in Apple and Disney and other individuals like him who have enormous stakes in companies? They are clearly not well diversified.

evileconboy said...

In the case of Barrick, do you mean sell or buy futures contracts on gold? Surely there is a difference in the intent it sends, not to mention implications about future liquidity of the firm.

fisherking61 said...

The counter to #5 (disclaimer: at least half of my professional career has been in proprietary trading) is that a prop trading activity has a dramatically lower fixed cost base than the traditional sales-research-corpfin IB backbone. In addition,prop trading performance tends to be positively correlated with the bond cycle (meaning, it has a somewhat long bias and tends to benefits from higher bond prices). As such, irrespective of the conventional politicall-correct remarks on earnings volatility, prop trading can actually perform a very precious countercyclical function and provide earnings exactly when the flow- and customer-dependent activities suffer from low volumes. It is indeed well-known that phases of turmoil encourage investors to retrench in the front part of the yield curve, where there is little money to be made to cover the high cost operations of a sales-corpfin-research arm. Amongst the IBs, for instance, it is not by chance that Goldman Sachs made killings in prop trading during both this recession and the last one, since they were less aggressive than their competitors in downsizing the activity earlier. In short, the gist of all the above is that prop-versus-the-rest is a simple volume/break-even point mechanism, with prop tending to do well in low-customer flow instances thank to a low breakeven.

Hemal said...

The point on Barick Resources, I think they would sell gold futures to reduce their risk and not buy.
Also, I think they should be hedging their prices or else, like some commodity houses, their stock will become worthless.

shikhil said...

In the case of Barrick, hedging against the gold price movement does make sense.

The company has two choices:
Hedging by taking OTM options as peterxys suggested would ensure meeting min. hurdle price.

It would also give investors good participation in the gold cycle.

2)Forwards / Futures:
Investors of the company will still be exposed to gold cycle; because production levels and capacity utilizations will touch new highs when there is more demand for gold. In other words investors will still benefit from higher quantity sold (higher sales and higher profit).

At the same time selling gold futures would help the company have a less volatile earnings (but still related to demand of gold)

But the biggest risk in case of futures would be the liquidity risk faced by the comp. MTM's could really wipe off the company (Metallgeschaft).

usequity said...

In the case of Barrick, it would be difficult to justify an options contract since it would have too much of time value especially in the case of the five year option contract.

However, commodity producers routinely get into forward/future contracts to have a smooth and predictable profit margin curve in the near future. Now, it could be argued that Barrick defines near future as five years.

On the other hand, I do agree with professor's argument that many investors in gold mining companies invest to get the upside in the price of gold. However, such major hedging contracts are always a part of the company's public financial information which a investor should check before investing. So, if the investor is not interested in a company that has booked stable profits for the next five years, may be the investor should simply look at other players in the industry.

anupam said...

Prof - Agree with you on Southwest airlines. But question is how much and how long should they hedge for.

I believe that SW airlines should not hedge long term and work towards passing any oil price increases to consumers.

They should hedge short term only to extent, where they have locked prices or published prices to consumer and cant revert back on those prices. Even that, they can reduce the hedging volume (and hedging costs) by offsetting it with the Aviation turbine fuel inventory (or locking price with ATF supplier)

what do you think ... whats their actual practice in reality?