It's hard to tell whether hedging with derivatives has generally benefited corporations or hurt them. It is commonly accepted in the financial world that hedging is a positive thing. Many see it as progressive and sophisticated. Recent research from Dr. Lisa Koonce from the University of Texas at Austin shows that investors reward companies that hedge with derivatives. "The results show that, holding constant the economic outcome, investors are more satisfied when the company uses a derivative. In fact, we found that investors reward companies for using derivatives by boosting their evaluation of management." Her research goes even further, showing that investors reward managers even if the company is worse off from using a derivative.
But is this justified? I think the positive aura around hedging with derivatives is misguided. It is understandable investors embrace hedging as an effective risk management tool. But hedging also has a strategic component that is often overlooked.
A firm might remove commodity exposure by hedging with futures, but from an industry perspective it is still exposed. Consider an industry that is heavily dependent on commodity prices, such as the aluminum can industry. An aluminum can manufacturer is naturally short aluminum, but it can hedge this exposure by going long in the futures market. This would be an effective risk management tool. But whether this is a good idea is ultimately not decided by the firm but by the actions of its competitors. Say Can Producer A hedges at $.8/per pound, Can Producer B hedges at $.9/per pound, and Can Producer C doesn't hedge at all. Can Producer A would seem to be the winner in this scenario since he hedged and did so before Can Producer B, ensuring less costs and a competitive advantage over Producer B. But if prices drop significantly, then Producer A is almost as screwed as Producer B, with Producer C being the clear winner. Southwest Airlines acheived much of its success because it hedged fuel earlier than other Airlines. But what if oil prices had fallen? It is likely Southwest Airlines would've gone bankrupt.
One assumption of this scenario is that companies generally have no idea where prices are going, meaning prices are as likely to go up as they are to go down. In practice, this is often not the case. For example, if oil is at $35/barrel then you have a pretty good idea it will rise. You see that now by the way firms are hesitating to use interest rate swaps to hedge variable interest rate exposure because they expect rates to stay down in the short term.
With this in mind, it is interesting to consider the current case of Barrick Gold Corporation, the world's largest gold miner. Barrick and other gold producers have historically hedged their exposure to price by selling gold forward. Barrick recently announced it was buying out its forward book, meaning it would sell gold at the spot price and would be vulnerable to a sudden drop in price as well as exposed to the upside. The FT reported the size of the industry's hedge book will drop to 200 tons at the end of 2010, down from 3,000 tons a decade ago. Barrick stated the reason for the move was "an increasingly positive outlook on the gold price." (John Dizard had an interesting article in which he pointed out that OTC derivative regulation would make it hard to maintain a large forward book anyway.)
Barrick's gold hedge is $5.6bn out of the money. I'm sure they have a good reason to buy out their contract, but they must have also had a good reason in January 1996, when it bought back its similarly sized hedge only to have gold drop from $415 to $253 three years later. From an investor's perspective, the move gives Barrick a higher beta because it will take on significantly more debt. But there should be another metric to measure Barrick's gold exposure, a hedge beta. A firm like Barrick is all of a sudden much more exposed to external prices and will behave more volatile than a competitor like AngloGold Ashanti, the largest miner left with a gold forward book. This hedge beta would be a useful tool because it would be based on industry. An industry where everyone is hedged at similar levels would mean a low hedge beta for hedged firms. An industry with wide ranges of hedges in place, like Gold, will mean a much higher hedge beta for Barrick and a low hedge beta for AngloGold Ashanti. For example, for an investor in AngloGold Ashanti, a low hedge beta would mean the investor has limited exposure to the upside and downside and therefore less risk.
This would be an interesting topic to research. I would expect to find that in industries with a wide range of hedge betas, success ultimately depended on where and to what degree one hedged rather than other factors. Either way, it is clear an investor shouldn't consider a derivative hedge as a prudent exercise in risk management. There are strategic risks to hedging. One must pay as much attention to the hedges of competitors as the hedges of the company itself.
