Amid all the risk-management techniques now available to large companies, few are generating as much debate in academic circles as hedging. In theory, hedging should help companies protect themselves against unexpected moves in exchange rates, interest rates, commodity prices and other economic variables. In practice, however, results vary depending on the design, execution and timeliness of hedging strategies.
The academic consensus seems to be that hedging can boost the value of a company, but only under certain circumstances. Recently, it has also become clear that the success or failure of a hedging strategy is influenced by the personalities of the individuals involved (principally, those of the chief financial officer or treasurer). Our understanding of this phenomenon has grown in parallel with that of “behavioural finance”, a relatively new academic discipline that examines human and social cognitive and emotional biases on economic decisions.
Why and how companies hedge
Traditionally, corporate finance theory assumes that all financial market risks are diversifiable. Yet this is not always the case. If one company invests in others to try to guarantee its supply of a particular commodity, for example, then it will still suffer from the imbalance of information – and, therefore, the small risk of exaggeration, obfuscation or deception – inherent between any set of shareholders and managers. Equally, it may be beyond the resources of a single company to protect the economies of scale on which its business model depends through traditional financial instruments such as insurance.
Hedging can mitigate against these problems, and against the high taxes that tend to result from volatile income streams under systems of progressive taxation. Furthermore, companies with fixed-cost business models, in which costs cannot be passed on to customers, can use the predictability offered by hedging to cope with big jumps in input prices.
Corporate hedging strategies can be based on financial instruments such as derivatives (futures, forwards, swaps and options) or on operating and financial policies (so-called “natural hedges”). Either way, they should reduce the volatility of future cash flows.
It is now possible to hedge against more risks than only currencies, interest rates or commodity prices using instruments such as weather derivatives, natural disaster derivatives and energy derivatives. Even more potent is the credit derivative, a relatively new instrument for which there is already a huge market. Thus, companies can hedge against the exposure of a major supplier or major client. For example, GM could possibly have mitigated against its ongoing difficulties with major supplier Delphi if it had instigated a well-designed hedge a few years ago, say, through credit default swaps. With outsourcing becoming a widespread business model, and contractors’ and subcontractors’ risks being passed directly to brand-owning clients, credit hedging may become the next source of competitive advantage.
However, it is important to note that executives may have personal reasons to implement hedging strategies that are not in the best interests of every shareholder. A recent analysis of the US gold mining industry, for example, found that managers with substantial shareholdings tended to hedge more, while those with substantial share options tended to hedge less. The inference drawn from this research was that the former managers wanted to protect their existing assets while the latter thought they could boost the value of their options through the volatility of their companies’ share prices.
The importance of timing
Perhaps the crucial factor in the success or failure of a hedge is its timing. This point has been illustrated dramatically by the airline industry in recent years, where some players have moved to hedge at the “right” time while others have jumped on the bandwagon at the worst point imaginable. Leading the former category is Scott Topping, corporate finance director at Southwest Airlines, a US low-cost carrier. He hedged his company’s fuel costs at a crude oil equivalent of $25 a barrel for 2005, and progressively higher prices all the way up to 2009. By contrast, most other US airlines waited until oil reached the astronomical figure of $60 before resorting to similar measures.
Different hedging strategies meant that Southwest faced an average cost of fuel of $0.95 per gallon in the third quarter of 2005, compared with $1.56 for Alaska, $ 1.70 for JetBlue and upwards of $1.88 for Continental and American Airlines respectively.
Southwest’s impressive results coincided with JetBlue’s first losses in five years – all because of hedging. David Neeleman who, as the founding CEO of JetBlue, engineered one of the most successful airline start-ups of all time, announced a comprehensive restructuring plan this year. This included the creation of a new vice-president position for fuel purchasing, and a hedging programme (through collar options, which restrict both upward and downward price movements to a narrow band) covering 35 per cent of 2006 needs at an average $68 per barrel, versus an equivalent coverage of 20 per cent in 2005 at less than $30 per barrel. Delta and Continental are scrambling to hedge their exposures at the going rate, abandoning previous non-hedging strategies.
Strategists at European airlines appear to be more sanguine and are showing greater continuity in jet fuel hedging policy. Thus, while Lufthansa is 90 per cent hedged, at an average $63 per barrel, for the whole year, super-discounter Ryanair has no fuel hedging in place after the end of October 2006. Moreover, Ryanair has promised customers it will not resort to the increasing fuel surcharges implemented by mainstream rivals Lufthansa, British Airways and Air France-KLM.
Appearances, however, can be deceiving. Howard Millar, CFO of Ryanair, said in March that the airline would consider fresh hedging only once crude prices returned below $60 per barrel. But CEO Michael O’Leary stated in February that the company expects high fuel prices to continue and would hedge requirements “should an appropriate opportunity arise”. So, on Tuesday, the company announced that it had hedged 90 per cent of its fuel needs from June to October, at an average price of $70 a barrel. Even the lowest unit-cost operator in Europe gets nervous when fuel accounts for over 35 per cent of operating expenses.
The tide in financial markets tends to turn when the last doubter has capitulated to the view of the majority, so is the airline industry at this point today? Arguably, we are witnessing the beginnings of a herd mentality in corporate hedging of the sort we have witnessed in all other market booms. So, the question must be asked: are CFOs beginning to act more like traders than corporate risk-managers?
Is hedging really just betting?
Why do so many corporations refuse to hedge currencies while just as many embrace the practice? What differentiates the winners from the losers? Is it possible to calculate the best possible time at which to hedge, or is the practice simply becoming a form of betting?
It is difficult to avoid asking these questions when one looks, for example, at the decision by Disney to hedge its yen exposure on its Tokyo park, at what turned out to be the bottom of a trough for the Japanese currency, and thereby deprived its shareholders of 50 per cent extra returns.
Similarly, BMW abandoned its profitable dollar hedge on US market exposure (the group’s biggest) in 2004, only to see its impressive sales performance over the following year tarnished by the rising euro. BMW’s change of strategy was triggered, according to company statements at the time, by what it saw as an undervalued US dollar. Thus, it was taking a position on the exchange rate, while its previous hedging policy was apparently a bet on what it viewed as an overvalued dollar. In May 2005, finance chief Stefan Krause warned that BMW would continue to be hit by the expiry of the currency hedging contract, and that losses could be far more significant in the future. A year later, Deutsche Bank analysts were telling clients that a 10 per cent drop in the US dollar would reduce BMW’s earnings before interest and taxation in 2007 by $570m owing to its minimalist hedging strategy.
By contrast, Porsche, which faced a similar exposure to the US market and had a similar strategy to BMW until 2004, extended its dollar hedge to at least 2008, and is still benefiting handsomely as a result.
With corporate hedging teams beginning to operate more like the fund managers of independent investment houses, shareholders clearly need to take a more rigorous interest in how corporate finance departments are run. These departments are no longer ancillary but of core strategic importance to many large companies. Their decisions on which risks to take and which risks to hedge can ultimately make or lose more of a company’s money than any other operation.
Why personality traits matter
Behavioural finance tries to shed light on why some corporate hedges succeed and others fail, by examining how individuals skew their investment decisions for irrational reasons. According to the theory, executive officers may be subject to “bounded rationality” – that is, to limitations of both knowledge and cognitive capacity – with the actual decision-making process influencing their decisions.
The most common behavioural traits that affect investment decisions adversely are described below.
■ Overconfidence Individuals tend to assign overly narrow “confidence intervals” (estimated ranges of values) to financial measures such as stock indices. In one recent survey, when individuals reported confidence intervals of 98 per cent (a high indicator of certainty) they were right only 60 per cent of the time.
Similarly, in another survey, over 90 per cent of people judged their interpersonal skills, driving skills and sense of humour to be above average. People are also poor at estimating probabilities: research shows that events they consider certain occur only 80 per cent of the time.
■ Belief perseverance Individuals are reluctant to search for (and to accept) evidence that contradicts existing beliefs. This trait is particularly prevalent among headstrong, high-ranking executives, because they often owe their success to an ability to hold steadfastly to visions and ideas.
■ Anchoring This term refers to the tendency to form initial estimates at arbitrary values, only to adjust them insufficiently over time.
■ Frame dependence Several experiments have shown that certain people find it tremendously difficult to move out of their existing frame of thought. The tendency is believed to explain why very creative individuals are often eccentrics.
■ Hindsight bias This refers to the inclination to see past events, regardless of evidence to the contrary, as being predictors of future events – it is a self-reinforcing trait that often has disastrous consequences.
■ Pattern recognition Discerning patterns in random data is a popular practice, but too often people think they can see value where none exists.
■ Herding Jumping on the bandwagon is perhaps the most well-known and common behavioural trait in business, as illustrated by the current state of panic among airline executives and the desperate purchases and hedging of oil at what appears to be a very high price.
Conclusions
Cognitive biases on decision-making may hinder significantly the performance of otherwise successful business models. Recognising the incidence of such biases and taking action to prevent resulting mistakes may be the key to developing both successful hedging strategies and broader risk management programmes within corporations.
Behavioural lessons are now well-used by the managers of trading floors, but awareness does not yet seem to have filtered up to corporate board rooms (even though everyone is aware of the tendencies of shareholders and entire markets to behave in irrational ways). Company executives must recognise both their own mistakes and those of others – and understand the behavioural reasons behind them – in order to avoid costly errors.
Didier Cossin is the UBS Professor for Banking and Finance at IMD. His research interests include risk assessment, structuring, management and advanced corporate finance.
Dinos Constantinou holds an MBA from IMD and is the founder of Global Microfinance Group.
