The thrill of taking risks can be exhilarating. The excitement comes from wagering a substantial potential loss to acquire a meaningful possible gain. This interplay is what draws us to extreme sports or to the middle of the desert to siphon money into slot machines. But when the wellbeing of your business is on the line, that’s not a thrill most people crave. Imagine how Warren Buffet must have felt going naked on his recent one billion dollar bet on the NCAA March Madness playoffs’ brackets. Buffet teamed up with Quicken Loans to sponsor the Billion Dollar Bracket Challenge, where a one billion dollar winning goes to anyone submitting a bracket correctly picking every winner and loser in the March Madness college basketball tournament. Alright, so in reality the bet was not that exciting at all. The odds were in the Oracle of Omaha’s favor to the tune of 9.2 quintillion to one. To put that into perspective, the odds of a Buffet payout were 1:9,223,372,036,854,775,808. But the fact remains, Warren Buffet put one billion of his own personal George Washingtons on the line with nothing but crossed fingers and some pretty compelling statistics to give him comfort.
What makes Buffet’s bet so exciting is that it was completely unhedged. Ok, so he wasn’t entirely without a contingency plan. He told the L.A. Times that if someone’s bracket made it all the way to the Final Four, he would offer to buy them out for 100 million dollars; pretty compelling when faced with the not-so-unlikely alternative of absolutely nothing. But the fact remains that he had no safety net, no option product, no insurance policy in the event that things turned south. This raises an age old question that applies to finance even more fittingly than it does to gambling; To hedge or not to hedge?
The Billion Dollar Bracket Challenge casts the question in the most extreme light: do you hedge against an imperceptibly small risk of a loss? Or, like Buffet, do you not bother with hedging because of the overwhelming probability that the cards will come down in your favor? The answer for those of us with real world business decisions lies somewhere in the middle, far, far away from the extremes resulting from a billionaire financial sage soliciting bets on 68 teams of early 20-somethings competing in a single elimination basketball tournament. So how should we think about this question?
Here are some important things to consider when deciding whether or not to hedge:
– What does the market data say? Yield curves can be a good place to start. The projected yield curve for 2015 is significantly higher and steeper than for 2014. This reflects the market’s expectation that rates will rise and is evidenced in the prices of heavily traded financial instruments. Last week, Federal Reserve Chairwoman Janet Yellen indicated that she expects reserve rates to begin to rise six months after tapering comes to a close. At the current rate, tapering should peter out in September, which would put rate increases beginning in March of next year. So should you hedge or not? Well, that depends on the exposure profile of your underlying business and EBIT profile, existing offsets to this exposure, and ultimately how much risk you can bear. However, even if you have floating rate exposure that warrants hedging, there’s a cost associated with reducing this uncertainty. Historically, it’s often the case that if you were to pre-hedge your floating rate debt, you would find that in a falling rate environment you may likely have paid more than if you had gone unhedged. However, in a rising rate environment, forward hedging has often constituted a savings over going unhedged. This is important to consider in the current environment where rates are near historic lows and the Federal Reserve is indicating interest rate bumps in the next 12 months. Market data suggests we’ll be in a rising rate environment, but we’re still left with the uncertainty of not knowing when or at what rate. It’s a bit like picking your bracket based on historical performance or team seeds rather than uniform color or mascot charisma: it’s more data-driven, but not always more accurate.
– What is your target fixed to floating rate debt profile? Hedging is a way to synthetically approach the right balance for your company’s needs, but how do you know what that balance ought to be? There are many factors to consider. For example, is your business model cyclical/seasonal, or is it relatively fixed? A cyclical business model with the flexibility to raise or lower prices quickly to keep pace with market movement can typically handle a higher floating rate debt profile than a more static business model or a highly leveraged firm, which often prefer more fixed rate debt. It’s also important to account for covenants or requirements from investors or board members governing risk tolerance. Another useful tool is peer comparison. Knowing what your competitors are doing can help you avoid putting yourself at a disadvantage from a price point perspective with your competition.
– What is the true cost of hedging? Understanding the value of a hedge versus the true risk of going unhedged is, for many people, the ultimate bottom line. There are many ways to go about hedging risk, and intuitively, removing more uncertainty typically translates to higher costs. But the maximum hedge is often not the optimal hedge from a holistic business perspective. Understanding the real value of what you are buying and what you stand to lose is no easy task. Pricing of derivatives is rarely straightforward. Even products with identical price tags up front can vary substantially in breakage considerations, credit terms, or even accounting implications. Structural changes such as adding optionality can give more flexibility, or help to mirror an underlying exposure profile, but can come at a steep price. In an environment like the one we are in today, where rates are expected to rise, buying disaster insurance can be cost prohibitive without an understanding of the costs and benefits involved. Deciding when the cost to hedge outweighs the benefits is a complicated affair that rarely yields up cut and dry statistics.
Unless the odds really are in your favor by a margin of 9.2 quintillion to one, you will likely need to face the question of hedging. The thoughts above will get you off to a good start, but navigating the ins and outs is tricky business, and absolute certainty is not something you can achieve at any price point. After all, who wouldn’t pick Duke to win in the first round? As a matter of fact, it only took 25 games, less than one round, for each of the 11 million brackets entered in the Billion Dollar Bracket Challenge to be eliminated. So now that your bracket is as busted as ours, tune in for Part 2 of our 3 part webinar series on IR Hedging. In the meantime, give us a call and let’s talk hedging, 610.925.3120 or email us.