Hedging Still an Effective Tool in Smoothing Company's Cost Structure
“Companies may not be hedging, they may be speculating,” says MIT’s Parsons. “There are companies who will have those gains and losses on derivatives because they’re basically taking bets.”
Warren Buffett nearly a decade ago referred to derivatives as “time bombs” fraught with risk of human error and mischief. Indeed, the trading of complex derivatives was blamed for the 2008 global financial crisis, prompting enactment last year of the sweeping Dodd-Frank Act, which seeks to impose new regulations covering derivatives transactions.
Even as those regulations are being written—and resisted by the financial-services industry— UBS recently revealed that it had suffered some $2.3 billion in losses from a trader’s allegedly unauthorized derivatives deals, leading the Swiss bank’s CEO to resign.
Parsons believes even non-financial companies could face exposure to the actions of an in-house rogue trader. Derivatives, though, come with less scandalous risks, as well.
A significant problem is “basis risk,” a potential mismatch between the hedge and the risk being hedged, such that they don't offset each other perfectly. This can happen, for example, when commodities are related but not identical, or are produced in different regions and affected by local conditions.
Over the past couple of years, Parsons notes, basis risk has posed a problem for airlines that lost money on deals using crude oil futures to hedge their jet fuel purchases.
“Basis risk is a big problem in hedging. Because of basis risk you hedge less than the ideal,” Parsons says.
In some cases, a hedge may simply prevent a company from making a bigger profit.
“Hedging is very important, but it’s kind of like a double-edged sword,” says the CFA Institute’s Haslett. If a gold producer decided to lock in its sale price at $700 an ounce and the metal rose to $1,500, the company would forgo the benefit of that increase, he noted.
Haslett recounted a presentation years ago from a gold-mining company CEO who said his company did not hedge. “They feel their shareholders buy their company to get an exposure to gold, and if they were hedging their gold product they would be limiting their profit potential should gold rise,” he said.