Hedging ... too often misunderstood

I believe that many misunderstand the role of hedging: some think it is the ideal approach when managing portfolios which are subject to the movement of various market segments, such as currency. Why wouldn't you want to hedge your global portfolio? Some think it guarantees that you'll lock in the local return, which is untrue (read Karnosky & Singer's monograph to learn more).

As John C. Hull wrote, "the purpose of a hedge is to reduce risk. A hedge tends to make unfavorable outcomes less unfavorable but also to make favorable outcomes less favorable." In his very well regarded Options, Futures, and Other Derivatives (7th edition), he provides an excellent example of how a hedge can work against you:

• President: This is terrible. We've lost $10 million in the futures market in the space of three months.  How could it happen? I want a full explanation.
• Treasurer: The purpose of the futures contracts was to hedge our exposure to the price of oil, not to make a profit...
• President: What's that got to do with it? ...
• Treasurer: If the price of oil had gone down...
• President: I don't care what would have happened if the price of oil had gone down. The fact is that it went up...

In this scenario, a company treasurer had placed a hedge on oil to protect the firm from a drop in oil prices. Southwest Airlines did something like this in 2008 when oil prices hit $140 a barrel. To reduce the firm's risk that the price of oil would continue to climb, a hedge was put on. But, the price dropped by 50%, meaning the firm lost a substantial amount.

Hedging limits risk but it also limits profit.

When it comes to the impact of hedging, it's important that your performance attribution system be conscious of its contribution. I've already cited Karnosky & Singer, but would recommend Carl Bacon's book as an excellent source to fully comprehend this model. Carl presents it relative to the Brinson-Fachler model, while Karnosky & Singer use Brinson, Hood, Beebower. Both should be in your library. And, if derivatives are something you're involved with, then Hull's book belongs there, too!