To Hedge or not to hedge?

During the last few weeks, the debate on hedging re-emerged as Prof. Joseph Falzon testified in front of the Public Accounts Committee investigating the Enemalta case. A titfor-tat ensued between the pro-hedging and the against-hedging camp with both camps putting forward arguments justifying their position. However, I am sure that most readers are still not able to determine whether hedging is right or wrong?

If you were to ask a finance specialist for an opinion on hedging, the answer would be pretty obvious to him/her and it would be a resounding yes. To a non-finance specialist, the answer would not be obvious and I suspect that s/he might tend to choose the option of not hedging. I think that part of the difference lies in the fact that those two camps look at events differently and are following two different approaches.

Last week’s news offers us an opportunity to explain this dilemma with a real-life experience. The receivers of the iconic Gherkin office building decided to put it up for sale. The reason is not that the original owners of the building did not manage to rent enough office space or that the tenants did not pay up their rent. It is simply a result of the original owners not having hedged. When the building was launched in 2006, the owners decided to finance part of the debt needed to complete the building in Swiss francs rather than in pound sterling. The main reason seemed clever, at the time, as they managed to raise funds at a cheaper rate. They hedged part of the foreign exchange exposure by having Swiss Re, the anchor tenant of the building, pay part of the rent in Swiss franc. They also entered into complex interest rate swap contracts. However, the unexpected and unthinkable happened. As the crisis unfolded, investors sought refuge in the Swiss franc and the latter soared by around 60% compared to precrisis level. Investors might have expected small fluctuations up to 10%-15% but certainly not the magnitude achieved. As a result, the value of the Swiss franc loan increased. Moreover, the crisis brought interest rates, which were already at record low levels, to even lower rates triggering fur- ther losses for the owners on those interest rate swap contracts. As a result the original owners of the building found themselves in negative equity and breached a number of covenants. The end came last week when the liquidators decided to pull the plug.

What are the lessons that we can learn from this on hedging? The first lesson is that no one can predict with accuracy future events. Anyone who contends with certainty that s/he knows whether the price/value of a financial variable will increase or decrease within a fixed future period is just buying his/her luck. Those who contend that they know will usually back their opinion with a number of reasons which make sense but anyone could find equally compelling arguments for justifying a move in the opposite direction. Even an investor like George Soros who became famous as he successfully bet against the pound sterling or John Paulson who made a fortune betting against sub-prime loans also get it wrong. Overall, they are successful because they get it more often right than wrong and also scale up their exposure when they are right and reduce them when they are wrong to limit the losses. As a result, anyone who decides to hedge is simply recognising this fact. I do not know the future price and I know that I cannot accurately predict the future price, thus, I hedge my position so that no matter what the future price might be I will not be negatively affected.

The second lesson is that unexpected events will happen no matter how unthinkable and extreme. There is always a first time. Anyone working in the financial industry knows that (Black Monday, LTCM, Dotcom bubble, September 2011, Great Financial Crisis, Flash Crash, Sovereign Debt Crisis, etc.). Furthermore, in the case of the financial markets, these extreme events tend to happen much more often than predicted by normal statistics indicators.

Unlike those who are in favour of hedging because they look into the future knowing that it is full of unknowns, those who tend to advocate not hedging tend to look back into the past and adopt a perspective which consists of pointing out instances where hedging proved to be the wrong policy. This is fairly easy to do as we know that on average prices will move half of the times upwards and half of the times downwards. However, as pointed out earlier this approach is wrong. After the fact, it is very easy to be right. You cannot use after the fact results when you have access to all the information to justify a decision taken beforehand when you only had partial or no information at all. The people advocating hedging will tell you that if you do not hedge, you will be right 50% of the time but the point is that you do not know when you will be right. Therefore, if you cannot afford to be wrong do not take that gamble.

But perhaps the biggest difference between the two groups is the following: those who know finance well know there is no such thing as a sure thing and that any open (unhedged) position is very risky and akin to a gamble. They know that this is the game they are playing and make use of safeguards, such as hedging, to try to maximise their chances of winning and more importantly avoid being wiped out by a bad gamble. Those who do not have a finance background might still have the illusion of knowing the future direction for sure or follow the advice of someone who convinced them that s/he knows and thus do not need some protection in the form of hedging.