Misconceptions About Hedging (continued) – This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com.
Misconception about hedging #5: Derivatives = Speculation.
This may be the most common misunderstanding in hedging. Warren Buffet’s now famous quote that “derivatives are weapons of mass destruction” (Berkshire Hathaway Annual Report 2002) has been over generalized by the media. Derivatives are merely tools, as are other financial instruments, that when used properly can offer an effective offset to an exposure to other risks, i.e. foreign exchange, interest rate, or commodity prices, for example. While there is no question that derivatives offer a vehicle to speculate on a highly leveraged basis, that is not their primary use in hedging, which is to reduce risk. Not managing one’s risks, and, therefore, the choice to float with market prices, is speculation whether it is by choice or naivety. This is not to say, that all risks need to be hedged and/or that derivatives are the only vehicle for managing such risks – the choice to hedge and with what comes down to ones risk appetite / risk capacity and other available alternative instruments / strategies. Contrary to the popular media, derivatives did not kill Wall Street during the financial crisis of 2008, unbridled speculation, combined with significant leverage, was a primary, but not only, weapon. DWS