This is just a quick note in reaction to the recent announcements by JPMorgan about $2 billion (and counting) trading losses emanating from hedging activities within the bank’s Chief Investment Office. Since hedging is our core business, we at Chatham Financial certainly hope the lesson the world takes away from these revelations is something like “Hedging is something you really need to do properly, or else you could make headlines for all the wrong reasons.” But to be clear, we don’t consider these headlines free advertising. Hedging has no business being on the front page of any newspaper. It is a practice associated with prudent and responsible financial management for many organisations and businesses. Well designed and executed hedging programmes are good for shareholders in that they remove or mitigate unwanted financial risks so that the managers can focus their attention on the risks they need to take as an organisation.
Today, though, we fear that some people will surmise that “Hedging is just another name for gambling and it will catch up to you sooner or later.” If you are tempted to come to this conclusion, we would stress the following points about the concept of hedge effectiveness, which is the central issue to the huge losses revealed in the past few days:
1. A perfectly effective hedge is an instrument that mirrors an unwanted risk. That is, its value will go up or down in the opposite direction with the same degree of magnitude as that of the underlying risk. Sometimes it is feasible to gain perfect or near-perfect hedge effectiveness, sometimes it is not.
2. An ineffective hedge’s value does not perfectly offset the value change in the underlying risk over the term of the hedge. This ineffectiveness can be present at the beginning or it could develop over time. At an extreme, an ineffective hedge’s value could move in the same direction as the underlying risk (compounding the risk), meaning that there could be minimal or no difference between an ineffective hedge and a speculative bet.
3. There are many reasons why a hedge might be ineffective, and this is why the hedge structuring process is critical to any hedge decision-making process. Structuring a hedge to be as effective as possible in all future scenarios is sometimes challenging, but usually this is limited to thin or under-developed markets. Especially when this is the case, all market-based factors should be integral to the hedge instrument structuring and the execution process (on the way in and on the way out), and the effectiveness of the hedge should be monitored on an on-going basis. Having contingency plans in place from the outset is also a good idea when effectiveness is likely to change over the term of a hedge.
It is natural for people to question the status quo when things go awry. Managers around the world will probably order reviews of their companies’ hedging policies and programmes in the near term, and this could be a good thing for businesses generally. In general, we would hope these reviews focus on the effectiveness of the hedges – whether they are doing as they are intended – not whether the hedges are assets or liabilities to the business, which can certainly be a temptation. If you would like to discuss anything related to your hedging policy, specific elements of your hedge programme, or anything related to hedging please do not hesitate to contact someone at Chatham for assistance.
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