Six misconceptions about hedging.

• Author: Stowe, David
• Position: Treasury

Is it any wonder many treasurers struggle in managing their companies' financial risks--given the complexities of deriving their exposures, valuing complex derivative hedging instruments and dealing with voluminous hedge accounting requirements, among other issues? However, those hurdles not withstanding, many miss the mark on a more basic way of thinking about risk management. The following addresses six misconceptions about hedging--issues often misunderstood or contrary to what is expected.

1. Risk is Absolute. The perception of how risky an exposure is depends on who you ask, since risk is relative and depends on a company's appetite for it. Every organization--even those in similar markets--approach risk management differently.

   One firm's risk appetite, or its capacity to absorb risks, can depend on several factors: Its business (why it's in a particular market or product); leverage (how much debt or other fixed cash obligations it must endure); liquidity reserves or access to liquidity (its ability to absorb cash flow volatility); or ownership (whether a company is public or private).

   It's not practical to do what another firm is doing since one approach may be quite different from another.

2. Risk Management Equals Hedging. Hedging--or offsetting one's exposure with an opposing financial position--is just one choice in the risk management process. There are three primary choices in addressing risk: Accept, avoid or manage it. The best choice depends on the company's risk appetite.

   If you choose not to accept or can't avoid the risk, then managing it begins at the operational level. Specifically, where can firms make changes in their production inputs, product markets, pricing and/or consumption levels to mitigate exposure? Once undertaken, it's the remaining risk that should be the focus for hedging, if this risk is still not within the company's risk tolerance level.

3. It's Important for My Hedges to Make Money. This premise misses the point in hedging. No prudent financial manager consciously decides to lose. The objective is more about providing predictability to cash flows, rather than making money or beating the market. It's the net exposure, or the combined value of the exposure and hedge position, that matters. The point: Don't cheer your hedges. The primary performance metric to consider is whether you, as risk manager, met the hedge objective, not whether it made money. Fear of losing on a hedge is an unfortunate reason for...