We always love hearing from our clients about anything, including things you would like to hear about in our newsletter. Today’s idea comes to us from Scott Free, Treasurer of First National Bank of Pennsylvania. Thanks, Scott! If you have something you would like to suggest for a future newsletter, let us know.

Hedging Draft - Chatham Financial

The NFL Draft played out the weekend before last amidst a flurry of franchise regalia and media hype. The draft itself is only three days long, but the amount of fan engagement, commentator banter, and analyst prediction is more than enough to expand this three day event into a season of its own. In fact, the NFL Draft season steps in to bridge the gap between the Superbowl in February, and the Spring League Meeting earlier this week, practically making NFL football a year-round event, much to the delight of diehard fans and hawkers of male-oriented products alike.

While Johnny Football and Michael Sam managed to monopolize the lion’s share of media attention at this year’s draft, one player made headlines for reasons that we at Chatham find particularly interesting. Morgan Breslin entered the 2014 draft after making a name for himself as a linebacker with USC. In the 2012 season, he buttoned down 19.5 tackles for loss (we’re still unclear on what half of a tackle looks like, but the stats don’t lie), and was 3rd in the nation for sacks, with a total of 13. Unfortunately, Morgan’s 2013 season played out slightly differently. Breslin suffered ankle and hip injuries which took him under the knife and landed him on the sidelines for over half of the games that season, to say nothing of what it did for his playing stats.

Football player stereotypes aside, Morgan Breslin is smart. In 2012, Breslin joined a growing number of college athletes purchasing loss-of-value insurance policy to hedge against the risk of their draft stock falling as the result of injury. And fall it did. At the end of the seventh and final round of draft picks, this once promising pass-rush specialist remained unchosen, and ultimately signed with the San Francisco 49ers as an Undrafted Free-Agent. If Breslin cashes in on his insurance policy (and he seems to have a pretty clear-cut case for doing so) it would make him the first college athlete in history to recoup potential future earnings lost to injury. His policy is rumored to be worth $750,000 to $1,000,000. The interesting case of Morgan Breslin transcends college sports, and highlights a few fundamental characteristics of an effective hedging strategy.

The first thing we learn from Breslin is that hedging needs to happen before you know that there is a problem. What 20-something doesn’t feel invincible? Even students who spend their college years in pursuit of highly un-macho pursuits like finance or accounting still likely have a cavalier attitude about their health. The proof of this is in the huge difficulty of getting this demographic to prioritize signing up for health insurance. A big tough guy like Breslin can probably brush off scrapes and bruises that would break most of us in two, but his actions showed prescience and sound judgment when weighing the risk of potential injury. Perhaps he had a trusted advisor who understood this risk and encouraged him to act while he still could. One financial analyst speculates that Breslin’s policy probably carried a premium of around $30,000 to $50,000 per year. Imagine if he’d tried to buy the same coverage after his injury. Forget about it. The same principal applies to hedging and risk management in finance.

Hedging is an exercise in prudence. It requires discipline and foresight to hedge against potential costs in the future, especially when current conditions present little identifiable risk, and can entice the less prudent into complacency. Besides, it’s only human to feel that money spent on a hedge or insurance policy that never pays out is money wasted. But change is inevitable, and waiting until things get bad to put a hedging policy into motion often means facing costs that are significantly more prohibitive. If Breslin’s policy never paid out, it would mean that he was drafted into a contract with a professional football team, and the payments he made under the policy would be more than justified. If a hedge never “pays out”, it means that interest rates never spiked, currency rates never dropped, commodity prices weren’t undercut, or any of a thousand undesirable events never took place, and the amount you paid under the hedge can seem a fair price to pay, especially if you prefer stable markets to disaster relief payouts. As difficult as it can be at times to accept the cost of hedging now when you don’t seem to need it, you’re much better off than if you wait until you do.

Another important truth that Morgan Breslin’s situation throws into relief is that the very existence of hedging can change markets for the better. The number of college players who forfeited remaining college eligibility to join the draft early this year was 256. Of those, 38 went unchosen, or very nearly 15%. Not only do these athletes no longer have any realistic prospects of a career as a professional athlete, they also have no college degree to fall back on. A major factor driving many athletes’ decision to cut school short and get to the draft is the fear that injury in their final years will dash their prospects of turning pro. Insurance policies that hedge this risk have the effect of encouraging athletes to complete their schooling without worrying over the economics of injury. As the number of athletes hedging this risk rises, the problem of athletes forfeiting their college degree should begin to decline. Current college football players holding outstanding insurance policies who plan to stay through completion include rising stars such as Myles Jack from UCLA and Marcus Mariota and Arik Armstead from Oregon, all of whom hold policies with coverage north of $5,000,000, who might otherwise forego a senior year to avoid injury.

The overall impact of this type of hedging on college athletics is decidedly positive: more athletes obtain degrees and the financial prospects for those who face injury are greatly ameliorated. The impact on financial markets of prudent hedging is, likewise, decidedly positive. The risk-reducing benefits of hedging are felt by the individual entities at the operational level, and by the markets as a whole at the systemic level. Individual entities that implement and execute sound hedging policies are less susceptible to changes in price, indices, interest rates, etc., which in turn reduces their risk of unexpected and often intolerable loss or cost. The fewer market participants that are exposed to these risks, the lower the risk that market participant defaults will domino across the market, and the system as a whole is safer for everyone. These are outcomes that appeal to regulators, market-makers and end-users alike, and there is little room for doubt that the responsible use of derivatives to hedge risk is a rising tide that lifts all boats.

We now find ourselves in an NFL armistice. The Draft is over, the Spring Meeting has sprung, and offseason training plays out largely below the radar of most national media outlets. What better time than now to take advantage of the lull and re-examine your hedging strategy before the next blitz? And while no one can predict what next season will bring, whether you’re a Treasurer or a Tight-End, a CFO or a Center, a Risk-Officer or a Running Back, a sound hedging policy today is perhaps the best way to face the risk and uncertainty of tomorrow. Give us a call at 610.925.3120 or email us, if you’d like to discuss your hedging strategy, or even just your 2014 Fantasy Football strategy.