Furniture Hedging

Although many people may not consider sports gambling as a hedge, a Houston furniture store owner successfully did just that. Jim McIngvale offered purchasers of more than $3,000 in furniture double their money back if the Houston Astros won the World Series. McIngvale has offered similar promotions on other sporting events in the past, but to date, none have worked out for customers. However, when the Astros won the World Series on Saturday, McIngvale was obligated to pay customers back. To hedge his risk, his first bet on the Astros was a $3 million bet in May at 10-to-1 odds. He added about $7 million more in bets over the summer at average odds of +750. Because the Astros won the World Series, he received $75 million from various sports books to offset the refunds payable to customers.

Pandemic Insurance

One way a company can alleviate risk is through insurance. For example, many companies have business interruption insurance (BII), which is a rider that pays the business owner if an event such as a fire or natural disaster makes it impossible to continue operations. If this happens, BII will pay the owner for lost revenue, an opportunity cost. Even though many businesses carry this rider, pandemics are excluded. For the insurance company, a fire affects few businesses at a time, and the losses are geograhically widespread and somewhat predictable for a large number of insured companies. With a pandemic, business interruptions are concentrated and much more numerous, as we have recently seen. Paying the large number of claims in this situation would bankrupt many insurance companies.

Recently, three major insurers have proposed that the Federal government create a plan to allow businesses to purchase BII that covers pandemic shutdowns. The proposed program would be modeled after the Terrorism Risk Insurance Act, which was enacted after 9/11. A similar program for individuals, which covers flood damage, is available to homeowners. On a personal finance side, we should make sure that you are aware that your homeowners policy will not cover flood damage. A separate policy, offered by the National Flood Insurance Program, must be purchased to cover this type of damage.

Loonie Taking Flight?

Since 2012, when the Canadian loonie reached parity with the U.S. dollar, the currency has taken a nose dive, dropping to a low of C$1.46 in early 2016. One benefit for Canada is that the cheap loonie created a trade advantage, helping that country's exports and benefiting the economy. With a better economy, whether the loonie will once again take flight is an important consideration for U.S. companies doing business in Canada. Strengthening of the loonie will increase the cost of goods imported to the U.S. from Canada, thereby reducing profits. These companies can lock in costs with forward contracts for commodities, or by hedging currency risk with futures, options, or swaps.

Delta Loses Big On Fuel Hedge

Companies with significant risks, such as currency or commodity risks, often hedge exposure to that risk. An industry with a a history of hedging is the airline industry, with companies often hedging fuel prices. However, not all hedges make money. For example, Delta Airlines recently announced that it lost $450 million on its fuel hedges in the second quarter of 2016 as it closed all of its hedges for the year. Delta is not alone as other airlines such as U.S. Airways and United have abandoned fuel hedges, citing lower fuel prices. We would like to point at that lower prices are not a good reason to eliminate hedges. By eliminating its hedges, Delta is now subject to the risk of increasing fuel costs. A hedge is designed to reduce volatility, so a reason to not hedge is the lack of volatility, not low prices, a fact often missed. Looking at the quote in the article from CNN Money: “Fuel prices are up 60% from their January lows, but they’re down 20% from a year ago. So, even with the cost of canceling its fuel contract, Delta will save money on fuel … in the second quarter.” While we agree that Delta will make more money with lower fuel prices compared to January, if fuel prices increase, Delta will not make as much as they could have going forward.

Citigroup's Swiss Franc Loss

In 2011, the Swiss National Bank pegged the Swiss franc to the euro, at a rate of 1.2 francs per euro. As recently as December, Swiss officials stood by the peg. Then, on January 15th, the Swiss National Bank unexpectedly removed the peg, sending the Swiss franc up up by 30 percent on the day. Unfortunately for Citigroup, the company had let it's Swiss franc hedge expire the previous week. As a result, Citigroup lost more than $200 million in the hours following the announcement. Of course, not everyone lost: It was reported that JPMorgan Chase & Co. had gained $300 million on the removal of the franc peg. The cost of the hedge was likely a reason that Citigroup allowed the position to expire. During the previous year, Citigroup lost $100 million on a hedge tied to unrest in the Ukraine.  

2014 Forex Hedging

A recent article in CFO argues that companies should consider hedging currency risk in 2014. The reason for the increased need for hedging is a possible volatile year in currencies. For the past several years, monetary policies across the globe were in relative synch, with growth a key goal. In the U.S., quantitative easing may be coming to an end, while policies in other countries such as the euro area and Japan are expected to remain relatively unchanged. This divergence in economic policies could lead to more volatility in exchange rates during 2014. During the first six months of 2013, a relatively stable exchange rate regime, U.S. companies lost about $7.7 billion due to currency fluctuations.

Hedging Risk

You would think that with the volatility in currencies, commodity prices, and interest rates that most companies would hedge these risks. A recent survey found that only about one-half of companies with these risks hedge them. Only 76 percent of the companies in the survey reported exchange rate risk, but only 52 percent hedge this risk. Only 43 percent of companies reported hedging commodity risk, and 41 percent hedged interest rate risk.

Risk Management In Name Only

One of the causes mentioned as starting the financial crisis that began in 2008 was the bankruptcy of Lehman Brothers. Lehman had a chief risk officer (CRO), Madelyn Antoncic, who was well qualified for the role. In fact, Antoncic warned Lehman senior management about the risk of the mortgage-backed securities that made up a significant percentage of the company's assets. Instead of listening to the warning and adjusting the company's risks, management took another route to solve the problem: They fired Antoncic.The replacement CRO had no formal risk management training. While Lehman was ultimately undone by taking excessive risk, it also appears that the company was undone by ignoring the person responsible for monitoring the corporate risk profile.

Interest Rate Swaps Go Standardized

Historically, interest rate swaps have been over-the-counter and had counterparty default risk. The Dodd-Frank Wall Street Reform and Protection Act requires that most derivatives go through a clearinghouse. In December, the CME (formerly the Chicago Mercantile Exchange) is debuting interest rate swap futures. Initially, the contracts will have 2, 5, 10, and 30 year maturities. At maturity, the contract converts into an interest rate swap. But, the purchaser or seller can reverse the position prior to maturity, which will allow for interest rate change hedging prior to maturity as well. While trading these futures will require participants to post margin. The advantages of these swap futures are a highly transparent market, the elimination of counterparty risk, and the access to liquidity to exit the contract at virtually any time.

Swaps Collateral

One of the major risks with swap contracts is counterparty risk, that is, default by the party on the other side of the contract. Even though the loss from an interest swap contract in the event of default is only the difference between the two payments, this can still result in a negative impact on the remaining party. The Dodd-Frank Act requires that the CME Group and other swap clearinghouses must now require collateral from both swap parties similar to the collateral provided in futures trading. The intent of the collateral is to reduce the risk of default and limit the impact in the event of a default. In order to allow the industry more time to resolve technology problems, the implementation of the collateral rule has been delayed until January 14, 2013.

Economists Learn Finance

One of the central tenets in Finance is the importance of market values and this is true when managing risks. When the recent financial crisis began in 2007, the models used by Federal Reserve economists were unable to explain the problems occurring in the economy. So, Finance came to the rescue. The Federal Reserve had always believed itself better informed than the market, but investors can provide important information about the risk a particular bank poses to the rest of the financial system. One of the new models being used by the Fed is the Marginal Expected Shortfall Approach, developed by professors at NYU's Stern School of Business.

Free Insurance

Recently, the term "too big to fail" has become popularly known. Too big to fail refers to those institutions that, if they failed, would have dramatic and rippling effects on the economy. Five large banks, JPMorgan, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs, fit this label. The assumption by most is that if any of these banks were to fail, they would be bailed out by the U.S. government to avoid a widespread panic. The implication for lenders is that any loans would be repaid by the government even in the event of a bankruptcy. This means that the lenders have an implicit put option on the debt and the borrowers can borrow at a lower interest rate than would be possible without the implicit guarantee. So how much is this bond insurance worth? One estimate puts the savings for the banks at $120 billion between 2007 and 2010. http://www.businessweek.com/articles/2012-07-05/the-price-of-too-big-to-fail

Ethics Swap

Britain's four biggest banks, Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland, have agreed to a settlement over mis-selling swaps to small and medium sized companies. Over 28,000 interest rate products had been sold since 2001. Problems with these products included poor disclosure of exit costs, failure to ensure customers understood the risk of the product, and over hedging. The announcement follows on the £290 million ($453 million) fine levied on Barclays earlier in the weeks for manipulating LIBOR interest rates. RBS and HSBC are still being investigated for LIBOR fixing as well. http://www.garp.org/risk-news-and-resources/risk-headlines/story.aspx?newsid=48927

Betting Against Yourself

Betting against yourself doesn't seem to make much sense, but maybe sometimes it can. Part of the $2 billion loss recently disclosed by JPMorgan Chase can be attributed to one trader who was selling insurance on corporate debt, also known as a credit default swap (CDS). But what is surprising is that a purchaser of these CDSs was one of the company's mutual funds! While this seems counterintuitive for two divisions of the same company to be making opposite trades, in this case it is perfectly acceptable. The trader for JPMorgan was attempting to make a profitable trade for the company, while the mutual fund was acting on behalf of clients. The fact that this trade made money for the clients at a cost to the company shows that the two divisions were acting separately, which should be the case for these two divisions. http://dealbook.nytimes.com/2012/05/15/as-one-jpmorgan-trader-sold-risky-contracts-another-one-bought-them/

Monte Carlo Analysis of Oil Prices

A Monte Carlo analysis may seem daunting at first, but as in many Corporate Finance applications, there are also other uses for Monte Carlo analysis. For example, a recent Monte Carlo analysis reveals the probability that gas prices will hit you in the wallet. http://www3.cfo.com/article/2012/2/capital-markets_oil-price-hedging-wti-crude-monte-carlo-simulation-options