Risk Management and Hedging Tools - PDF

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					                                         LANE: It is our philosophy that if       an already existing exposure - or
                                         you're 50% hedged, that's kind of        more than 100% of your exposure?
                                         the neutral position. You have no        LANE: We do not. Our stated
                                         view. What we try to do is to            mission, as I mentioned earlier, is to
                                         analyze the market and determine,        minimize risk. So, even if we felt
                                         based in part on our judgment            interest rates or currencies were
                                         about the likely size and direction      about to move in a given direction,
                                         of future price movements, what's        we would never use foreign
                                         the best position for our company.       exchange products or interest rate
                                         We don't say we know where the           products to create a new risk, or to
                                         market or rates are going. But           add to an already existing exposure.
                                         based on the particular conditions,      McKNEW: How about the rest of
                                         and based on what our competitors        you? Does risk management mean
                                         are doing and what we're trying to       totally eliminating risk as best you
                                         accomplish, we end up hedging            can do it, taking into consideration
                                         somewhere between zero and 100%          operating variables and, therefore,
                                         of each individual exposure.             measured exposures? Or does it
                                         McKNEW: So, you're managing              mean sometimes managing risk
                                         risk as opposed to eliminating it        down and then managing it back up
                                         totally. John, what do you think         based on some view of a market rate
                                         about this? Are you always hedged?       or price?
                                         VAN RODEN: No, we aren't                  VAN RODEN: We try to manage
                                         always hedged. The steel business is      risk, but not to eliminate it.
                                         a very cyclical business. And we          McKNEW: So You would
 Risk Management: Hedging                will not hedge more than 50% of           increase risk if you felt that a
 or Speculation?                         our nickel supplies precisely for that    certain currency or commodity
                                         reason. That is, we could plan one        price was going to move in a
McKNEW: Thanks, Lynn. Now, I'd           year that we're going to sell X tons      certain way?
like to open up the discussion to the    of steel, but sales may well end up       VAN RODEN: That's right. For
panelists and to everyone in the         being only half of X. And if in that      example, if we had a strong
room. But let me start things off by     case we hedged the entire amount          conviction that nickel prices were
asking each of the panelists a very      that we planned to sell, then we          not going to rise and might even
basic question.                          would be significantly overhedging        fall sharply, we might well choose
    Tom, when you're hedging, do         - we would end up with a very large       to increase our exposure to nickel
you trade? Do you make money             uncovered long Position in nickel         by reducing our hedge.
hedging? JONES: We do not trade,         futures.                                  McKNEW: Okay. So, does anyone
but we may report gains or losses on        So, in this sense, yes, we do          think there is anything particularly
a derivative position from time to        trade. in fact, our team will get        wrong with that?
time. We are not a profit center. Our     together every week to evaluate our      JONES: Well, it sort of depends on
use of derivatives is consistent with     position. And if we were 50%             what you mean by increasing risk.
Carbide's overall risk management         hedged at a given time, but we felt      If you say, 'I've got 5 million Dills
program - a strategy that reduces, but    there was going to be a big Move         coming in, but because I think the
never increases, the financial risk of    LIP or down in the price of nickel,      dollar is going to strengthen, I'm
the company.                              then we might increase or decrease       going to hedge 10 million," I would
McKNEW: Lynn, I assume you                our hedge to reflect our view.           say, "No, we don't do that." We
would say that RJR doesn't trade          McKNEW: Okay, so it sounds as            manage only the risk associated
either.                                   if all of you sometimes trade, at        with our operating cash flows. We
LANE: That's essentially right.           least in the sense that you allow        don't volunteer to take trading risks
McKNEW: But you earlier said that         your view of the market to               independent of those cash flows.
you typically hedged less than 100%       influence your hedging position.         And we don't double up existing
of your currency exposures. Why           But, do any of you ever consciously      exposures or get into leveraged
would hedging anything less than          create risk? That is, do you ever        derivatives.
100% hedge of an exposure not be a        hedge less than 0% - say, like              But, having said that, there are
trade, a kind of speculation?             Orange County, by doubling up            financial risks associated with
any hedging position you choose to         it. Even if a hedging strategy ends up    that are incurred in legitimate
take. We don't choose to create risk,      improving Your competitive position       hedging operations.
but you have risk one way or the other.    relative to other companies, nobody       ROY: What you're saying, then,
If we do a derivative, we've taken a       will ever credit risk management for      Tom, is that losses on derivatives are
risk. If the position produces losses -    that - the credit will go instead to      subjected to much closer scrutiny
even if it's a well - designed hedge -     marketing or strategic planning. But,     than losses resulting from leaving an
you may have difficulty explaining         if You're wrong - say, the hedge loses    exposure unhedged. For example,
them to management. Life is full of        money and your competitors react          let's say you were receiving an inflow
risk. But we don't try to create any       differently than expected - then          of DMs, and that because you
additional risk.                           everybody will know about it.             expected the dollar to weaken, you
                                           Explaining to people that you made a      chose not to hedge the exposure. In
You Can Hedge, But Don't Lose              fundamentally Sound decision that         such circumstances, you would
Any Money Doing it                         didn't work out is a very difficult       receive much less criticism if you
                                           message to get across.                    turned out to be wrong by failing to
McKNEW: In identifying your                LANE: That's right. Unfortunately, in     hedge than if you had instead hedged
financial exposures, do any of you         today's market, people focus on the       the DM with, say, futures, and those
take into account the expected effect      tools instead of the underlying           futures ended up producing a loss -
of price changes on your competitors?      exposure. People in risk management       even when those futures were
That is, in setting your own hedging       are often judged according to how the     hedging an expected cash inflow.
policies, do you consider your             tools perform, and independently of         So unhedged, or "natural," losses
competitors' exposures and how they        what happens to the underlying            that increase volatility are preferred
will react to the price changes?           exposure.                                 to "artificial" or derivatives losses
LANE: I think this kind of analysis is     ANIRUDDFIA ROY: Yes, that's               that actually serve to reduce overall
potentially very useful. In setting a      very true. Even when companies are        volatility. Do I have this right?
risk management strategy, YOU              supposed to be hedging, in practice       JONES: Yes, that's right. We all
Ought to know how your competitors         the success of the risk management        have friends in the financial
are positioning themselves to handle       function often seems to be judged by      community that say they wouldn't
their exposures. In fact, that is one of   how much money they make on their         hedge because derivatives are bad
the reasons we think that a 100%           derivatives positions. But, in a          things to use. The irony, of course, is
hedge amounts to taking a very strong      properly      run    corporate     risk   that by making that statement,
view of the market. If you hedge           management operation, the treasury        they've effectively made a decision
100% of your exposure in the forward       cannot operate as a profit center. if     that they're going to accept the risk.
market, but prices end up moving           you are really hedging, and not just         But this hypocrisy, or at least
against your hedge and in favor of         taking positions, you ought to be         confusion, persists in part because the
your natural position, you are giving      expected to show losses from time to      two kinds of losses don't get
up the upside. And if your                 time. And that ought to be clearly        accounted for in the same way.
competitors are not hedging in this        understood by management and the          Unhedged losses don't show up
case, then your competitive position       board from the outset.                    anywhere, they aren't broken out into
could suffer.                              JONES: I agree with you that that's       a separate account; and so the board
JONES: I agree, at least in theory,        how things should work, but it's also     never sees it, and the media never
but I am not sure that this kind of        clear why companies don't want to         report it. But hedging losses are
analysis ends up producing any basis       report derivative losses of any kind,     reported separately - typically
for hedging policy. We have done           legitimate or otherwise. Take the case    independently of the position they're
some studies as to where our               of Carbide. As a company, we're           being used to hedge - and they are
competitors source their raw materials     doing very, - very well today. And        now being held up for very strong
and what currencies they're paying in.     nobody wants something to sidetrack       scrutiny.
But such studies have never really         Lis by having a derivative loss that      LANE: You're both absolutely right.
caused us to change our strategy.          gets a lot of publicity in the current    This kind of double standard goes on
 McKNEW: Well, the problem I've            environment. And I don't think            all the time, and I have yet to see
 always had with trying to sell that       Carbide     is    unusual    in   this.   much attention - certainly not in the
 approach to corporations is that if       Managements and boards everywhere         popular accounts of derivatives -
 you're right, nobody ever knows           are very concerned about derivative       being devoted to this problem.
 about                                     losses, even those
Can You Hedge
Without Speculating?                       For example, you might say that your      views on certain markets and we do
                                           policy is always to hedge at least 30%    take financial risks. But we do it
STEPHEN PAGE: I'm a little                 but never more than 100% of a certain     through a team and so you get the
confused about what I've heard so far      kind of exposure (and the kind of         opinion of a lot of people. And you get
in this discussion. Everyone says they     exposure ought to be identified as        the opinion of the operating people, as
are trying to avoid speculation. But, at   clearly as possible). Or, using Tom's     opposed to those of us who don't have
the same time, everyone also seems to      policy at Carbide as a model, you         responsibility for bottom line.
say that they are willing to let their     might say that you will never deviate         I would also mention the
hedging decisions be influenced by         more than, say, one year from your         importance            of        regular
their views on interest rates or           targeted interest rate duration of four    communication and reporting. As of
currencies. In my view, if you have a      years.                                     next week, we will begin sending
DM transaction exposure and you            JONES: Well, Bob, I'm not sure you         monthly updates to management
leave it up to a local treasurer to        can ever formulate policy with that        outlining our positions and strategies
decide whether to hedge or not to          degree of precision. When you get          for all the various commodities we
hedge the exposure, then you are           into project financing or a joint          consider hedging. Now, this won't
effectively encouraging a form of          venture, it may be easier to provide       prevent us from making bad
speculation.                               very clear objectives. For example,        decisions. But, if we turn out to be
   Now, if we surveyed the people in       let's say the success of a project is      wrong, at least we will all know why
this room today, we would probably         based on obtaining an all - in             it happened.
hear ten different views of the dollar/    financing cost of no more than 9%. In     LANE: I earlier mentioned the
DM. So, this tells me that it depends      that case, if the project financing was   importance of considering your
only on who your treasurer is at the       based upon a 9% interest rate and you     competitors' exposures in developing
time as to whether or not you can          succeed in locking it in at 8 - 1/2%,     your own risk management strategy.
speculate. it seems to me that if you      then even if rates end up going to 5%,    But let me elaborate on this point a
hedge anything less than 100% of           you've done the right thing. Now, it's    little, because I think this point bears
your exposure, you are choosing to         true your venture partner may say to      on how you distinguish between
take an open position, you are taking a    you after the fact, "Well, why didn't     hedging and speculation. if you hedge
speculative position.                      we get the advantage of the downside,     100% of a currency exposure and the
McKNEW: I understand your point.           why didn't we get 5%?" But, as long       dollar goes against you, but your
I've always had problems with the          as your objective of beating 9% was       competitor has chosen to leave the
imprecision, or even confusion, that       clearly stated from the outset, and       same exposure unhedged, then your
surrounds the terms in this business of    your partner was part of that             ability to maintain market share - that
risk      management.        "Hedging,"    understanding, then this is an            is, your competitive position - - could
"speculation," "trading," "risk -          effective risk management program.        end up being reduced by your hedging
taking," risk avoidance" - we all seem         But things are different in a large   decision. So that's why I say that
to be using these words somewhat            corporation, with multiple exposures     hedging either zero or 100% of an
differently.                                and where everything is changing         exposure may involve taking a strong
   So, when someone begins by saying        daily. It is much tougher in such        view.
that their treasury is not a profit         cases to formulate objectives that are    ST. JOHN: I tend to agree that the
center, but they add value by taking        not subject to change.                    distinction between hedging and
views on a selective basis, that               And, by the way, I agree               trading is not clearcut. I too am not
statement raises questions about the        completely with Steve's distinction       sure that you can hedge without
objective of the risk management            between hedging and speculation,          taking a view. That is, whether you
program. And, because this kind of          and we have lots of discussions of        choose to hedge 0% or 100% of an
confusion is so widespread, I would         these terms at Carbide. If we believe     exposure, your position will never be
argue that unquestionably the most          the dollar is strengthening or            completely insulated from changes in
important step in risk management is        weakening, then we should either be       financial markets. And so I think the
figuring out exactly what you're trying     zero or 100%. If you're in the middle,    objectives     of     corporate    risk
to accomplish. And your corporate           it's not clear what you are doing: Are    management          programs       will
objective should be expressed in very       you hedging or speculating?               inevitably have to leave some room
specific terms, if possible even with       VAN RODEN: I'd just like to add to        for taking speculative positions or
quantitative indicators of success.         that. We at Lukens obviously do have      trading, if you will.
PAGE: Well, I would like to               risks that we take in trading             hedges but not the positions being
disagree. I think corporations can        accounts are explicitly quantifiable      hedged give you a reliable guide to
practice risk management without          and usually explicitly offsettable,       the performance of the risk
taking a view. For example, you can       more or less simultaneously.              management function?
say that you are going to cover           JONES: Bob, why do you want to           VAN RODEN: We actually do
100% of all transaction exposures.        be paid for it if you don't take any     something      like   what     you're
And, at the same time, you can say        risk?                                    Suggesting, Bob. For instance, in
that you will attempt to hedge all        McKNEW: I fully realize that the         the case of nickel, we mark Our
your expected cross - border              Lord don't owe me a living, and if I     hedges to market every day. At the
translation exposures based on            don't take any risk I won't get paid.    same time, on a weekly basis, we
current forecasts - for example,          But, in fact, we get paid in part for    update our forecast of total nickel
much as MCI hedges its expected           making markets for our customers,        costs for the rest of the year based
overseas payment to its PTTs.             and in part based on the outcome of      on current nickel prices. And
   Now, although this approach            those positions we choose to take in     combining these two measures that
doesn't     completely      eliminate     the process of serving our               is, actual costs based on current
currency exposure (because your           customers.                               prices plus hedging gains or losses -
actual exposure may turn out to be            But that brings me to another        allows us to project our total nickel
somewhat different from what you           point. I live in a mark - to - market   costs and their effect on bottom -
projected), it neutralizes the effect      world. Everything I do is marked to     line earnings.
of currency changes on your                market on almost a real - time
expected operating performance.            basis. I know when I go home            McKNEW: SO, using current price
And that may be the best you can           every night how much all of the         levels, you would estimate both your
do. in this kind of risk management        activities in my department have        expected nickel costs and your
system, you will have effectively          made or lost, plus or minus a few       expected hedging results? And this
eliminated any role for subjective         thousand dollars. And this is real,     would in turn give you some basis
judgments about future currency            hit - the - income - statement - of -   for judging the effectiveness of your
moves; you will not be taking a            the bank kind of money.                 hedging program relative to either
view.                                         But these obvious differences        doing nothing or, say, hedging
   Moreover, if you do lock in a           notwithstanding, I'm essentially in     100%?
given currency value by hedging            the same business that all of you        VAN RODEN: Yes,                 that's
100% of expected exposure, then the        are in. And, for this reason, I'm        basically right.
resulting increase in your level of        curious as to how many of you           McKNEW: That's interesting. Does
certainty about translated year - end      mark to market, in any sense, the       anybody else do anything similar to
results can help you in setting your       risk management activities you          that? ... No response. I wonder why.
pricing structure and in establishing      engage in. Put another way, if you      Is it because the accountants don't
targets for managers of foreign            are not always 100% hedged, how         require you to do it? Or is it because
operating units at the beginning of        are your decisions not to hedge         you cannot develop the systems
the year.                                  100%        being     reported     to   capable of doing it?
                                           management? And when I say              ROBERT BUTLER: We do
                                           "reported," I mean expressed in         something like this on a once - a -
Mark - to - Market Reporting                                                       year basis. But I think the main
                                           such a way that somebody in senior
of                                                                                 problem here is that setting LIP
                                           management can look at your
                                           decisions and evaluate them against     such systems is a costly undertaking.
                                           an explicit, unambiguous standard.      It's not something that goes into the
McKNEW: As a market - maker                I'm talking about meaningful            financial statements. It involves
and trader in derivative instruments,      internal or management accounting       calculating      all   the     various
I actually can be in a position of         systems, not just adhering to           exposures, and, perhaps even more
taking no risk simply by choosing to       external reporting conventions.         difficult and time - consuming,
do nothing. In overseeing trading          JONES: We mark to market daily          getting      agreement      on     the
accounts, I can say - at least in          all of our derivatives positions, but   calculations.       If   performance
theory that I will take no risk; I will    we don't do the same for the            evaluations and treasury group
just not write any tickets myself, and     underlying exposures. Is that the       bonuses are going to be affected by
completely offset everything that my       direction you're going in?              how you estimate the exposures,
customers bring to me. In that sense,      McKNEW: Yes, but that only              then reaching agreement could be
my job's a lot more straightforward        serves to support my point. My          difficult.
than all of yours, because virtually       question is: How does marking to         McKNEW: Yes, I see.
all of the                                 market the

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