Is hedging really about predictability and not profits

Yes, for many operating companies which want to stay focused on their core biz, hedging is a mechanism for damping cash flow volatility ("operating" hedge) rather than making plays on FX movements ("speculative" hedge).

Very generally, the nonlinear, concave wealth-utility function of the typical risk-averse investor means that the market will pay a bit more for a cash flow consisting of a certain $100, say, than one which will either be $75 or $125, each with a ½ probability. Hence there's a stock-price motivation for narrowing your cash flow swings.

The internal budgeting and forecasting process also usually benefits when (for example) you know you're getting $100 next month, rather than maybe $75 or maybe $125. Makes it easier to plan your expenditures.

That's really oversimplifying and scratching the surface, but those two are fairly common motivations underlying operating hedges, and they illustrate the general idea.

That's not say, of course, that many operating companies don't wade around in the shallow end of the speculation pool, if they feel they have the in-house talent to do so, but usually that activity will remain ancillary to their primary biz.

David perfectly answered.

Companies from the "real economy" should focus on making money on their core business: selling shoes, IT services, food, etc.

Thus, you hedge to create certainty about your revenues and / or costs in foreign currencies. If your projected gross profit margin is 50% and your projected bottom line is 10%, what you want is to be sure to achieve this forecast.

It is very important to understand that IF YOU DO NOT HEDGE YOUR FX RISK, YOU ARE SIMPLY SPECULATING GIVEN THAT YOUR PROFITABILITY WILL DEPEND ON THE FX MARKET VOLATILITY.

Brian is correct. Corporate hedging programs should be focused on preserving margin, not making money. The corporation will not be immune to currency moves, it will just postpone the impact of currency movements. If the hedged rates are effectively communicated and used by the company's forecasting function, hedging can be a great tool, providing management with foresight and the ability to plan appropriate responses to sudden negative or positive movements that will be impacting them in the future.

Hedging should be all about protecting profits!

The general premise that hedging should be about smoothing volatility is correct in this instance. However, there are some important considerations. The first is that in an ideal world the "correct" hedge will be a NET hedge. In other words, if you are hedging the receipt of revenues in a foreign country (for a subsidiary, for example) with a forward currency hedge (a forward purchase of that currency), you may want to consider that there may be expenditures in that same foreign currency (by that subsidiary) that already exist - working, in effect, as a "natural hedge".

Calculating the sum of all the mitigating or natural hedges in place may be complicated if not daunting. And other "natural hedges" may exist that are not immediately self-evident. I used to have a movie-chain client who had a large number of bank loans on a floating rate basis (they were exposed to the future direction of and volatility of floating interest rates). They took the position that they had a "natural hedge" in because their VIEW (more on this concept in a moment) was that when the economy was down, (floating interest) rates were down, and when - conversely - floating interest rates were up, the economy was generally up, hence more business and more money to "foot the bill" for the higher rates.

This ignores discussion of the movie industry as either more or less "recession resistant" than interest rates, but does serve to illustrate another - more subtle - point, obliquely relevant to the concept of "natural hedges". One often has an embedded VIEW which in an of itself contaminates a "hedge neutral" - or more correctly - "risk neutral" policy. From an equity "price risk" perspective, for example, if you have equity positions in foreign stocks and you have taken those positions because you like the companies that you own shares in, wouldn't it make sense to hedge the currency risk (hedge it OUT of the equation)? Yet few people do this, and hence becoming witting or unwitting currency "speculators" at the same time. And there is yet another example of this I will refer to later (regarding a beverage company).

This concept of a "natural hedge" extends itself in most treasury departments to include the balancing of assets with liabilities. Airline companies, for example (or utilities) - which have "long life span" assets (or gas contracts) will borrow on a long term basis. In this way they avoid - or "hedge away" - the "refinancing risk", that is, the need to re-borrow to continue the financing of a long-lived asset (like a plane).

Second, one needs to at least consider the concept of the "herd mentality". This is not to make excuses for moral hazard, but rather that human nature does tend to veer towards CYA behavior. If you are the CEO of an airline, for example, and none of the other airlines are hedging their jet fuel costs, what is the cost to you if you hedge (fix) your fuel costs and then fuel costs plummet? All other airlines will reap the unintended windfall, and you will be a pariah.

Third, one must consider the concept of 'basis risk' - or the risk that the thing you want to hedge and the tool or asset you use to hedge that thing must be based on the same underlying thing. In other words the hedge and the thing to be hedge must match exactly and move in opposite directions in exactly the same way. While exchange-traded hedges are often not custom-tailored enough to provide precisely the right hedge (different quantity or different maturity), over-the-counter negotiated hedge contracts can typically offer just such custom-tailored hedging. In such cases, however, one typically needs to have a relationship with a dealer or bank who will execute such hedges, which requires a credit line, a banking relationship, etc. etc...

Fourth, there are complex tax and accounting rules around hedges. They get more complex when the hedge is put on (executed) domestically for - for example - the receipt of foreign currency at a foreign subsidiary. In addition, there are frequently "mark-to-market" rules which mandate that all or a portion of the hedge must be "valued" at the end of every reporting period and that positive or negative deviations from the purchase price of the hedge (often zero, in the case of forwards) must be included in P&L (or more accurately, that changes in the value of the hedge since the prior reporting period must be reported). This is less of a problem when you actually own (or owe) the asset (liability) being hedged, as would be the case on interest hedges executed on a floating rate bank loan. But it can be a problem when you are hedging the anticipated receipt of funds in a foreign currency. If you execute a hedge one year in advance, for example (same would apply to hedging fuel costs one year in advance), then your hedge will get "marked to market" at the end of each of the quarters you own it - potentially introducing Income Statement volatility that would not have been there absent the hedge - in some cases the very problem you are seeking to avoid!

From years in the business as a professional hedge marketer across a range of asset classes (interest rates, currency rates, equity prices, and so on) I can tell you that my advice has always been that companies should "stick to their core competences", which typically doesn't extend to predicting and/or profiting from the future direction of interest rates, currency rates, and so forth. In practice, however, it is often very difficult to make the case for an increased cost - or a perceived increased cost). How do you argue, for example, that it makes sense to lock in your borrowing rate at 3.5% for 5 years when floating rates have been below 1/2 % for almost a decade? Its precisely from an ignorance about the "sensibility" of such pro-active hedging activity that a sharp, forward-thinking TA (treasury associate) is likely to be up-braided by his CFO for adding an "extra $X million" (or $ hundred thousand, or whatever) of "expense" to a company's borrowing cost by locking in rates.

I will also veer off the track a bit to suggest that hedging - in addition to be a pro-active means to smooth out volatility, and more importantly a means to "hedge away" the risks you or your business do not have core competencies to manage, can also be used in "out of the box" ways, to enhance the value proposition of a sale to a potential customer. If you are selling products in US dollars to foreigners, or in foreign currencies to US buyers, for products with long lead times or far-dated delivery dates, then you can offer a "built in" hedge to that customer by offering to sell to them in the currency of their choice. You can then, ex-post sale, cover any risk you have assumed by hedging it away. This example is meant to illustrate that their are creative uses to hedges besides a simple "take it or leave it" stance with respect to internal risks.

Finally, in the long run, things do tend to "even out". I used to cover a mammoth, global beverage company, for example, that never executed a currency hedge at all - even though they sold goods in every country and currency in the world. Their position was that "it all evened out", and that to pick specific currencies to hedge - let alone to embark on a massive, portfolio-wide currency volatility smoothing campaign across all currencies - would, in and of itself constitute "speculating".

At the end of the day, then, hedging needs to be put in the context of a) your level of sophistication to deal with all of the byzantine rules and processes for executing hedges, accounting for them and reporting them, b) what the rest of the crowd is doing, and c) what the penalty for not hedging entails. If the penalty is minor COGs volatility that's one thing, but if a wild swing in an asset or receivable will put you out of business, or run you up against the stops in cash-flow, then its best to hedge, even if it means locking in a level or a price that - as a "monday morning quarterback" - you may have to defend later.

Bryan,

Adding my two cents (in part mirroring some prior comments);
Forex speculation (or as Mark points out, other related speculation) is in my perspective, unless you are in the business of speculating, a potentially very bad thing to do. On average, you will lose as the act of speculating has both internal and external costs. That is of course if you make it that far and the "law of large numbers" catches up to you. Short term you have worse-than-even odds of losing money. Explaining to your board that instead of focusing on widget sales, you instead lost the shareholders' money gambling, is a conversation which will not endear you to them.

I've always resorted to natural hedges as my starting point; beyond that do a risk analysis of areas where there is the ability to put in a net hedge *and* that this is an act that hedges a material risk to the business, not just an act to smooth revenue/expense. Then, before putting it in play, make sure the stakeholders are bought in.

My two cents' worth...

As everyone has said "hedging" definitely means damping volatility in the business's results and not speculating. In my experience, unlike David's, I have more often heard of taking views on the market as "active risk management" than "speculative hedging" just as hedging itself is often called "passive risk management".

The point I'd like to make though is - even if you want to damp volatility on your business results - not all active risk management is speculation! The difference between the two is that speculation is done when trades are done based only on the direction of the financial markets, ie without knowledge of the underlying risk positions, whereas active risk management is done when both are known and management know of the risk, approve of new positions and keep control of both.

For those with significant currency risk in their businesses the situation is more subtle and the solutions put in place should be more sophisticated.

So, here are some practical suggestions from someone who has set up regional and risk management programs for three different corporate companies, including IBM, in several parts of the world:

1) Big movements can and should be hedged first through natural hedging where possible, as Keith says. After that, bank or exchange traded financial instruments should be used depending on the size of the company, all as described above.

BUT... and as explained excellently in Helen's recent webinar ... none of these hedges will be perfect. In real life amounts and dates received & paid out will not match (sales are not as high as forecast, receipts don't arrive on time, exchange rates have changed between date of expected receipt and actual receipt etc, etc). Dates are as important as amounts because the exchange rate can have moved a huge amount. A 1% movement in a day (not unusual) is equivalent to a 360% interest rate difference! That puts it into perspective.

What can you do about it. Answer:

2) Get advice from several sources AND TAKE A VIEW ON WHERE MARKETS ARE GOING. That's not speculation, that's just being intelligent about what to do with the remaining risk.

When the risk has changed enough to warrant a change in the hedge, fair enough, change the hedge. The key however is to do your best so that the remaining risk you have (amounts and dates) is that you're more likely to make money than not if your assumptions on market directions are right!

Mark has a point of course - There are many accounting and tax issues associated with hedging and these need to be considered. However it's not cut and dried - For example you have to decide whether you are managing risk just to make your accounts look good or (using my own words) so as not to lose the value gained by the rest of the business, two completely different things.

Why bother with so much effort if the remaining risk is small? Answer:

3) There are many reasons but, in my view, most of all because of what they call 'Tail Risk'... Here's an analogy: If you don't follow the weather forecast, you won't know that a tornado may be coming. You're protected as far as storms are concerned, you're maybe even protected against the financial value of what is lost in a tornado. However nothing will replace the sentimental value of what is lost, your personal history. That is your remaining risk! A significant loss caused by an unusual but very dramatic event. How do you protect against it. You know what possessions you have that could be destroyed, you watch the forecast and the relevant news. You make sure you've tried out your contingency plans. You're then in a good position to protect all you have!

The same is true for financial risk. Knowing your possessions is having as good a cash forecast as possible, watching the forecast and news is tracking the markets, trying out the contingency plans is using the active risk management regularly to make sure what you have works.

The problem with passive risk management techniques is that - because no one follows and then uses the information on market directions - there is no one in the company with an understanding of possible impacts of unusual but severe events in the markets. This is not something you can learn about overnight, nor is it something you can pick up from expert advisors at the last moment. You need discrimination (which advisor is better, in what circumstances), infrastructure (bank lines, company policies, dealing authorisations), quick decision making processes and more.

There are other reasons for having someone with an informed view of what's happening in the markets - setting the 'right' rate when pricing contracts, setting a better rate in a plan, knowing how to analyse currency exposures [not as obvious as you may think, if they're complex], hedging vs the competitor's currency advantage. Even just understanding what those external advisors are talking about! Add these to the tail risk point above and I hope you'll that agree a wise CEO, CFO or Treasurer will have someone in their organisations who is responsible for and effective in this.

In summary - Hedging is good; speculation is bad; taking a view of the markets for active risk management can be well worth while. So think about it! Cheers...