January 31, 2011

Americans have a nose for news that’s personal and hits home. So it should not surprise anyone that a self-proclaimed “Tiger Mother,” on a book tour with her memoir on parenting, managed to alarm us more about global competition than Chinese President Hu Jintao did on his official state visit to Washington. While politicians expressed concern during Hu’s visit over China’s increasing economic and geo-political might, unequal access of American-made goods to Chinese markets, and a currency peg that continues to frustrate global trade, parents across the land awoke to the realization of something far more frightening – that our children will need to compete with their children, for jobs and opportunities, and to advance in everyday life. Yale Law Professor and Chinese-American Amy Chua’s new book, “Battle Hymn of the Tiger Mother,” has sparked in us something personal, and has us questioning our own techniques in the face of her strict, disciplined approach.

While many readers of her book will see it as primer on how to raise a successful child, we at Chatham recognize her tenets right away as one approach to running a successful hedging program, but one that must be tempered with some flexibility. It’s worth exploring how this philosophy applies to your hedging policies, and understanding the limitations to this approach. Disciplined risk management is the key to getting the most benefit from your hedging program, but common sense should always prevail.

Hedging Policy. The fact that your company has a hedging policy is a good start! A disciplined approach to hedging will not be reactive, but rather proactive and well thought out in advance of any transactions. The policy should identify the specific business risks you intend to manage, the derivative products you are approved to use to manage these risks, and the people who are authorized to transact on behalf of the business (Incumbency Certificates), at a minimum. A more disciplined approach will also include specific scenarios and criteria for which hedging is required (i.e., all floating rate loans over xx years will be capped or swapped, for example), and the criteria for assessing, selecting, and transacting with your counterparties. Your hedging policies should be approved by your board of directors, and the appropriate employees should be trained on and familiar with their contents. This disciplined approach will provide the framework and default positions for the majority of your risk management decisions.

Practice and Repetition. In her book, Amy Chua recounts how she made her daughters practice the violin and piano every day, for hours on end, until they got it right. Applied to hedging, a disciplined approach would also include extensive practice and repetition. But if you are not in the markets that often, what can you do? The key is to go into each hedging opportunity as it comes along, with the same process of derivative construction, review, and trade authorization, while building comfort and familiarity with the process. Also, since Chatham is in markets every day, transacting derivatives on behalf of our clients, you are able to leverage our market color and knowledge to increase the benefits and understanding that comes with your own transactions. By using the tools and information you have available, and by applying a consistent approach to all of your trades, you will be better able to recognize and adjust to those situations that might fall outside your standard procedures and hedging policy.

Managing Exceptions. Taken to the extreme, the philosophy of the “Tiger Mother” would mean that policy always trumps reality, regardless of present circumstances. Clearly, when it comes to derivatives, there are problems with this approach. For example, if by policy, you were restricted to transacting with only AA+ or better rated counterparties, you might find no one to trade with, or find that you have a counterparty that fits this criterion, but transacts at a much greater cost. Or you may be obligated by policy to hedge a larger amount or longer time than necessary, regardless of your plans to pre-pay a loan or sell an asset. An intolerance or inability to manage exceptions could lead to results that are contradictory to your hedging intentions. Hedging policies should be revisited and reviewed with some regularity, to ensure they still make sense in light of the changing OTC derivatives landscape. Just as we would warn against weak, reactive hedging decisions, we would also express concern for those decisions that fit policy precisely but defy common sense. The benefits of a disciplined, “Tiger Mother” approach to hedging are quickly lost when strict adherence to policy causes you to lose sight of business objectives.

If you have questions on your hedging policies or procedures, give us call! Chatham can help you build a disciplined hedging program, but still keep you rooted in reality!