Hedging means different things to different people. For example, a bank manages its interest rate risk by converting everything to a variable rate. In this way, the balance sheet is floating, and interest rate movements only make minor changes to value. On the other hand, a company views hedging as a fixed cost of money, and therefore the interest payments are known. Looked at from either perspective, both approaches make sense, but they are different.
When we talk about hedging, we think of matching risks so that they net out. However, in truth, this is very difficult. If you hedge everything perfectly, you are flat, but the cost of doing this can be excessive because you are continually entering into transactions to transfer the risk to somebody else, and this costs money. Financial institutions recognise this, and despite talking about hedged risk, often there are remaining mismatches which are far from hedged. There's nothing wrong with this because these exposures are part and parcel of running a business. However, we do need to understand exactly what is matched and what isn't.
One of the big problems is that risk reports fail to show the nuances of hedging adequately. This failure to show where the risk lies can go unnoticed for a very long time. Furthermore, even if it doesn't show in the P&L it comes out in the wash at a later date.
As a consequence, not only do we have a situation where you cannot see the risk, there is no immediate way in which you can feel the risk affecting the value of what you are doing.
A classic situation where this occurs is with what we can call loosely basis risk, where hedging is 90% accurate. During normal times, the 10% unhedged risk causes little problem, but occasionally, it can assume a disproportionate value, particularly when markets have been disrupted.
It is also useful to be aware that these basis risks are frequently not caught by risk limits, and traders know this. In this situation, if you put pressure on dealers to make more, these unreported exposures are more likely.
Another feature of these risks is that they start off being quite small, but over time the balance sheet grows, and with it, the exposure increases.
It is therefore important to ask whether you have captured all the things that influence the real mark-to-market.
Let's put that into perspective: at a micro level, it involves putting together individual trades and the hedges that go with them and asking, "What affects the value of the package?". If some inputs or scenarios can change the value of what you have, then by definition, you are not fully hedged.
If you do this properly, you will find a whole series of situations where balanced books simply aren't that. It may be benign, but we need to get some idea of the magnitude of the risks that are being run. Here, estimates or approximations are incredibly powerful because they can put the exposure into context for you. Is it small, medium, or large relative to the size of your business, the profits that you are making, and the skill sets that you have?
One of the preferred tools I like to use is simple delta values, that on their own don't tell you about how much you can lose, but they can give you a good insight into the size of the risk you are potentially running. It's a type of smell test; if it's ripe, it probably isn't palatable.
These simple methods can be extremely helpful if you are not conversant with what drives day-to-day changes in value. Traders have a model of risk largely built in their heads, and they can determine when it's small, medium, or large based on their experiences of the past. It's a sort of human value at risk model. It takes time and skill to develop this insight, and for many people, a simple back-of-the-envelope calculation can provide some surprising insight into what's going on.
The next time you hear that the risk is hedged, dig deep to find interesting results.
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