A 50% hedge, while it has the same 1.6 return/risk profile, is a better strategy since the risk is cut in half. But, that is about hedging, which is boring.
I remember back in 1987, I was recently returned from the US and was quite new to financial markets. After the stock market crash, gold had set off on a wild tear, like it has today, hitting new all-time highs every day. I was at a Forex Conference in Goa, and oiled with several drinks, I was pontificating about how gold, which had just crossed $400 an ounce would reach $1,000 in (I think) two weeks. A (not so) shy, (not so) quiet gentleman at the pool said he would bet me that it wouldn’t. We settled on Rs 10,000, which was a pretty big bet for me in those days, but I, of course, had no doubt.
The date came and went and gold was nowhere near $1,000—in fact, it peaked at $450 or $460 and slid lower. I counted out my Rs 10,000 and sent it to the winner in an envelope. He sent is straight back to me, and try as I might, he wouldn’t take the money. He said the bet was a joke. I said if I had won I’d have taken the money, but he was adamant and wouldn’t take it. [I tried to reach him on Facebook last week to take another bet, but he didn’t respond].
Today, there are lots of forecasts of $2,000 an ounce (and even one I saw of double that), but I started leaning in 1987, and know now that, sure as you may be, the market will never respond to your views. Or, more correctly, it will follow your views sometimes, just enough to convince you that you can figure it out—and, then when you have a huge amount on the line, it will turn away laughing.
Which is not to say that you shouldn’t have a view on the market, which is impossible, but that you should never bet the house on it. Indeed, if you do bet your view, make sure you set a stop loss and follow it with discipline.
Failure to do that—setting a stop loss and following it with discipline—is why most hedge strategies end up with only modest results, even at large, highly professional companies. This modest (and, indeed, sometimes, outright poor) performance doesn’t generally show up in audit reviews because FX, (a) seldom breaks the bank (the period of 2007-09 excepted), and (b) is quite arcane and, humans being what they are, most treasury professionals are able to convince themselves—and their bosses, which is easier—that they are doing quite well or very well.
The primary reason for this is poor benchmarking. Companies usually measure their performance against their budget rate, which is usually set at a level so conservative that a blind man throwing darts would outperform it in most cases. Some companies pride themselves on beating the spot rate at maturity, and sometimes by a handsome margin. But, given that over the last five years, a simple Day 1 12-month export hedge (which has the additional value of carrying zero risk) outperformed spot at maturity by more than 2% on average, this is hardly a significant achievement.
Again, the reason why most strategies fail to achieve what would be even an average performance—which, in other operating areas in most companies, would lead to major process surgery—is because of the disinterest in setting and/or inability to stick with a stop loss.
To my mind, the first thing that needs to be determined for any hedge strategy, including the very common “I can figure out the market”, is to measure the risk it carries. If, say, the treasury has freedom to hedge based on its views, it means (again, for a 12-month export) that it has been given license to risk nearly 10% of the fully-hedged value of the exposure. I find it hard to believe that any board would be comfortable with carrying that kind of risk. To be sure, the rupee does fall precipitously from time to time and there is a 5% chance that the spot rupee can fall by more than 16% over 12 months. This would give a return to risk ratio of 1.6, which is not bad, except for the fact that the risk level is huge.
A 50% hedge, while it has the same 1.6 return/risk profile, is a better strategy since the risk is cut in half. Better yet, is our structured hedging programme that carries very, very little (near zero) risk and, on average over the last 10 years, delivered about 0.5% better than the 50% hedge.
But, that is about hedging, which is boring.
Does anybody want to bet when gold will cross $2,000 an ounce?
The author is CEO, Mecklai Financial. Views are personal