Sunday, May 20, 2012

Hedging: Weapons Of Self-Destruction?

Every year Germans elect the "Unwort des Jahres"  (faux-pas word of the year). My favorite for this year is the term "hedge " or "hedging". This phrase is very popular in the world of finance. It means in its origin: When you make an investment in asset A you also invest in asset B which price develops inverse to the price of A. If A falls, B rises. Because the gain with B compensates for the loss with A both assets together (your portfolio) are balanced and free of risk. Hedging is a kind of insurance (wikipedia).

The JP Morgan fiasco finally unmasked this term and shows that "hedging" very often is confused with gambling. Last week JP Morgan`s CEO Jamie Dimon confessed that his bank has lost $2 billions because some "hedging operations went wrong" ( Losing $2 billions (more may come) shows that these investments weren`d balanced at all ( (seekingalpha). Instead the bank (their trading department in London) was betting on an expected fall of a sophisticated index which is bound to complex derivates. Contrary to their expectations the index rose, causing this huge loss.

It isn´t unusual that bank employees are playing with complex derivates in the hope to boost their career by making high profits for the bank. Many of these derivates are very sophisticated because they are based on very advanced mathematics which is seldom understood. Warren Buffett called these mathematical constructed products "weapons of mass destruction" because very often they cause gigantic losses.
The JP Morgan traders tried their luck with an index which is bound to Credit Default Swaps, known as CDS ( Those instruments are related to the debt of a company, a country or a community and are regarded as insurance in case the debtor goes bankrupt. If the situation of the debtor gets worse the price of the CDS rises. But this attribute is luring many speculators who buy CDS as a bet that they can benefit from the worsening situation of the debtor.

These days many speculators (mainly banks and hedge funds) are buying CDS on the debts of Greece, Spain, Italy and even France as a bet on the bankruptcy of these countries. These purchases are raising the prices of these CDS which are traded on financial markets like stocks and other assets. But rising CDS prices are regarded as a sign that the situation of the debtor is worsening. Therefore these speculative purchases are aggravating the debt situation and work as a self-fulfilling prophecy.

It is interesting that the involved hedge funds are a misnomer. The term "hedge fund" suggests that the fund is hedged meaning that their assets are fully balanced. But the typical hedge fund does quite the opposite. It takes high risks for instance by financing purchases with credit (leveraging) or investing in highly speculative assets like futures, CDS and other derivatives. Very often these hedge funds show a herding behavior, meaning that a large group is betting on the same expected event, like the bankruptcy of Greece or rising oil prices.

Presumably the worst misapplication of the term "hedging" happened in the year 2008. In the first half of 2008 the oil price was rising steeply even as the recession had already begun and stock prices were falling. Some of the banks who permanently bang the oil drum claimed that investing in oil works as a hedge against falling stock prices. Many speculators followed this advice which worked then as a self-fulfilling prophecy. These speculative purchases, camouflaged as hedging, drove the oil price to $147 which sharpened then the recession.

I believe therefore that - while the basic idea of "hedging", meaning taking provisions against risks and unexpected damages, is reasonable, - the term is very often misused and a camouflage for a destructive behavior. The JP Morgan fiasco is just the latest example.

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