THE ILLUSION OF HEDGING

When we start reading the basics of hedging we read the case of the poor humble farmer. The professor explains that the poor farmer grows wheat and has no control of the market prices. When he actually sells it the price can either increase-he makes a profit or falls - he books a loss. To protect his interests we have a process called hedging. Here the farmer has already gone into a long term contract at a fixed price. This saves the poor farmer from price fluctuations of the market and his risk is eliminated.

But is it really so? Is there no risk? Have we transferred the risk completely?

Contrast the case with a Steel company. Suppose the company hedges the cost of iron ore (my raw material) and fix it(by a long term contract ofcourse) . What happens now? Suppose the iron ore price goes up the company wins.

But wait a second. Suppose it goes down now I loose. But it’s not as simple. What about other companies, my competitors? If they have not hedged the raw material cost they can cut the prices of steel. So either I need to cut my prices of steel or wont be competitive. I can only choose my way of death. But just hang on. I hedged to negate this very risk which I am still facing now. So we see that hedging doesn’t really eliminate the risks. It can bring forth new ones. Many companies in the past have hedged and lost big-time. Airlines industry is a great example.

Hedging has its own share of risks. We need to understand them before we make a decision. Often the problem is the companies go by the bank’s advice and do not understand the risk’s involved. More on the banks next time.