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