We finance folks have the propensity to confuse the heck out of everybody on simple terms (or issues) relating to finance. We will sit around talking derivatives lingo and other market issues like its alien- speak to others – it really, is not! I usually say to people:
•It is not that difficult
•If I cannot explain my model, in words – i.e. what the model is, what is does and how it does that, I have no business just plugging in numbers, “letting it calculate”, then looking at a number and saying “Well, this number means XYZ” – that is utter nonsense and is one of the reasons why the financial mess in 2008 happened – people not knowing more than just “that number”!
•You must interrogate what the terms and ensuing numbers and operations mean – if you don’t understand exactly what an ABS (Asset Backed Security) is, what it does, how it works, what the end result is intended to be, variations to, relation to other market variables – seriously, you have no business, just “doing ABS “on the quantitative front – because really, what the heck are you doing?
•The market place is very dynamic; what worked in 2007, might still be relevant today (or not), but certainly needs analyzing to ensure it still fits! That business of “this is how we do it” – yah, that doesn’t hold water for serious minds.
Simply stated at first – and I intend to go into detailing in subsequent posts to explore the different facets pertaining to hedging. (I hope to be a better blogger in 2013 – because I am always writing something, someplace anyway!)
What is? Hedging is simply the practice (art and/or science) of minimizing losses in your portfolio. It will mean, you make an investment of some kind to ensure that the value of your assets is protected from adverse price movements in the market.
All you are trying to do is ensuring that at the end of it all, your $1 is at least still equal to $1 and not $0.98. The goal of course, it to ensure that your $1 yields some profit, but at the very least, you are not trying to lose any money, no matter what the market dynamics are.
We hedge because of imperfections in the market; ideally, prices should adhere to demand and supply forces. They do not (sometimes, most times actually!) and there is therefore, the potential to make lots of losses if we do not employ strategies (hedging), to accommodate for the volatility in the markets. We therefore hedge to minimize risk exposure in markets (and hence maximize opportunities presented by these very same financial risks, while factoring in the cost of the hedge). We hedge to manage market risks – in a nutshell.
What do we hedge?
Commodities (agricultural or non-agricultural), credit risk, currencies, interest rates, weather (yes, we do have weather derivatives) etc.
How do we hedge?
First you must consider the general organization’s policy and objectives on risk management. This would include types of hedging employed, limits and other guidelines that define the what to do and what not to do as far as hedging is concerned. This is absolutely important, because hedging can never provide cookie-cutter solutions; it is a subtle balancing between market dynamics and organizational objectives. It must be what works for you (which is why as a consultant, I can never, ever recommend generic hedging strategies for a company without understanding the key underlying issues of that company, in relation to market dynamics at a particular point in time while anticipating expected future results and trends)
Then, you develop a strategy that works or you (and I will be detailing specific hedging strategies in follow up posts), and implement and monitor said strategy (usually will be a combination of various methods). You will need to have a strategy that is viable both qualitatively and quantitatively – Like I observe, if doesn’t make sense in words, it probably will not in numbers!
I find that proper documentation of hedging (and risk management strategies as a whole) is imperative to ensuring constant review of implementation, controls and adjustments.
Some forms of hedging will include (but not limited to): futures contracts, options, swaps, forward contracts, EFTs etc) as applied to commodities, currencies, interest rates etc.
My next post will focus on better definitions of some of the terms referenced to in this post……Then we will keep going. Happy 2013 folks!