Misconceptions About Hedging – One would think that after many years’ worth of ‘experience’ with hedging that we would have the subject down pat; that we would no longer have any misconceptions about it. We landed on the moon in ’69, yet we still have various misunderstandings when it comes to hedging. Confusion about Global Warming
I can understand, it’s new (ok, we’ve been talking about it for a long time, but to recent converts – it appears new, or even suspect). But hedging? Some very smart people have been writing about it and/or doing it for a very long time. There are at least two truisms in life that I believe: “…nothing can be said to be certain except death and taxes” (B. Franklin), and effective risk management, which may involve hedging, enhances a firm’s value. Nevertheless, the subject remains misunderstood. Or, as with any subject, there are different opinions on it. 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 #1: Hedging Eliminates Cash-flow Volatility.
This is more of an irony than a misconception, and would depend on a company’s particular situation with its counterparties (see Strategic Treasurer’s Treasury Update Volume 5 – Spring/Summer 2009). When the posting of cash as margin for the unrealized loss of the hedge portfolio is required, the volatility / unpredictability of cash flow due to margin calls can actually worsen, as opposed to mitigate, hedging’s primary objective, which is generally the predictability of cash flow. Currently this may be situation-specific — dependent on a company’s credit standing and bilateral negotiations with each counterparty, it may, however, become a significant issue for more firms if proposed regulations for the over-the-counter derivatives market end up requiring a central clearing mechanism for all trades. DWS