Sent: 31-03-2009 13:42:02
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When Hedging is Speculation
Hedging is a term much abused by companies speculating about the direction of financial markets.
Hedging should not impose additional commercial risks on a company. True hedging should eliminate risks. And, yet, companies continue to get into strife from what they refer to as hedging policies.
An example of the purest form of hedging is where a copper smelter buys copper in the form of copper concentrates for further processing into metal. The concentrates might take three months, say, to process before the resulting metal is sold. The copper price could vary between the time the concentrate is bought and the time the metal is sold, putting the smelting company at risk of a loss or, if the price rises, an unanticipated profit.
The smelting company could eliminate the risk when it makes the initial purchase by simultaneously entering into futures or forward contracts to sell the metal for delivery when it is scheduled to be available after processing.
If the price subsequently falls, the value of the forward contract will rise by enough to offset the negative effect of the lower price on the revenue from the metal being produced. Conversely, if the price rises, the positive impact on the potential metal sale price will be offset by a corresponding loss on the forward contract.
In doing this, the hedging company needs to be careful to ensure that the timing of the forward contract coincides with the timing of the metal sale and, secondly, that the basis on which have the physical metal is being bought and sold is the same as the basis for setting the price in the forward contract so that day to day price fluctuations will coincide. In the copper market, this would normally be achieved using contracts and prices based on quotations from the London Metal Exchange.
In contrast to this model, a wine producer might conclude that the Australian dollar, having fallen from 95 US cents to 65¢, is very low and likely to rise. It "locks in" the 65¢ rate by buying Australian dollars for a range of forward dates to cover future US dollar denominated sales proceeds. Similarly, a gold producer might think that US$900/oz is a high price that will be preferable to potential realized prices in the future.
The resulting financial outcomes will depend heavily on how good company executives are at forecasting a range of macroeconomic variables. If the currency does subsequently rise, wine company profits will be higher than they otherwise would have been. However, if the currency drops, profits will be lower than the company would have otherwise experienced.
From a stock market perspective, the risk in these outcomes may not be symmetrical. In the former case, where there is an unexpected profit from buying the currency, the market is unlikely to treat the result as a continuing possibility. It is unlikely to push the share up as though the result had come from better wine sales. Where profits fail to meet expectations because of unanticipated currency transactions, the market could easily force a medium term downward re-rating if investors fear that the company could repeat the error.
During 2008, Matilda Minerals, a start-up mining house, sold its future U.S. dollar receipts from mineral sands sales at what proved to be the top of the market in the current cycle, fearing that the currency could go higher. It subsequently dropped 30%. At the lower exchange rate, Matilda could have operated profitably but, by then, it was too late. Directors had already given the company over to administrators. This outcome had less to do with the mining and operational skills of the executives than commercial judgments they were poorly qualified to make.
Macarthur Coal, a Queensland based coal miner, last week reaffirmed its commitment to a currency trading strategy which involves selling 85% of its anticipated U.S. dollar sales proceeds forward as soon as it negotiates its annual sales contracts. In the extreme, if all the contracts are completed on a single day, 85% of the revenue for the coming year is tied to the level of the currency on that day despite sales occurring over the subsequent 12 months.
An alternative approach would be a form of dollar cost averaging in which the company could sell some U.S. dollar receipts every day to get to the average for the year. Either way, a risk is incurred. Neither is truly hedging.
Any judgment about which way to translate foreign exchange exposures should be based on what is in the best interests of the company's shareholders.
Accepting the average through the year seems to leave shareholders less open to an adverse turn in conditions than betting everything on one roll of the dice by selecting price on a single day.
Production could fall short of what is expected when contracts are signed leading to a lower than expected rate of shipments. The currency obligation would remain. If, at the same time, the Australian dollar falls in value, the company incurs a cash loss for which there is no physical sales offset.
Macarthur was caught in that position and had to roll forward currency positions that were due for settlement this month by buying them out and selling an equivalent amount for a date in September. The company asserted last week that the transaction had strengthened its financial position. It could make that claim because its financial position had been compromised by its currency market speculations.
This has been a more obvious risk in the resources industry as the economic cycle has turned down and several raw material buyers reneged on their contractual obligations to take scheduled shipments but is present among all companies with material international transactions.
Such transactions can also make it hard for shareholders to understand a company's profit drivers. The loss of transparency from sometimes complicated derivatives transactions might not be of great concern to shareholders in the unlikely event that all the decisions consistently go the right way. But we should all be less inclined to concede that possibility in the light of the global experiences among trading houses in the past two years.
Shareholders of companies using such devices can find it hard to understand whether historical profits are sustainable or simply the result of a one-off financial speculation. In the face of such uncertainty, the market will be inclined to pay less for any given earnings stream.
Ultimately, anything less than the purest form of hedging which cuts risk and adds to certainty jeopardizes investment returns. No matter how sophisticated the financial market transactions or how prestigious the corporate adviser urging the company to use them, they are of questionable value to shareholders if they lack transparency or add to earnings volatility.
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