During last month’s hearing of the US senate banking committee, senator Richard Shelby asked Jamie Dimon, the CEO of JP Morgan, whether trading activities which resulted in a multi-billion dollar loss for the US banking giant could be considered ‘hedges’. “I have a hard time distinguishing a bright line between prop trading and hedging”, was Dimon’s response. The JP Morgan case, which involved trades which were essentially indirect hedges of a somewhat abstract exposure, highlights the often complex relationship between hedging and speculation – perhaps best exemplified by the tongue-in-cheek classification of a hedge as any trade that loses money.
As corporate treasurers, we are often quick to draw a distinction between hedging and speculation. Hedging is a responsible activity, where the sole objective is to remove the impact of unpredictable market volatility from financial performance. Speculation, on the other hand, is much less acceptable, a dark art associated with wild-eyed pit traders and hedge fund cowboys, rather than straight-laced treasury professionals. But, as Jamie Dimon’s comments and the recent JP Morgan trading loss highlight, the line between hedging and speculation is not always as clear as we might like to believe.
There are a few factors which highlight the difficulty that often exists when attempting to draw a clear distinction between hedging activities and speculation. Academic studies (e.g. Bodnar et al, 1998) show that companies usually incorporate predictions of future price levels (i.e. a ‘view’) when executing hedges (a fact which will come as no surprise to most risk management practitioners). If hedging is really just about reducing risk, then why should our expectations of future market direction have any bearing on our hedging decisions? If we hedge 50% of our exposure, instead of 80% or 100%, because we feel that the price / rate of the underlying exposure is more likely to move in our favour, does this meet the criteria for speculation?
Secondly, there is no clear consensus (beyond narrow accounting definitions) on what constitutes an ‘acceptable’ underlying exposure for hedging purposes. If the actual exposure cannot be clearly ascertained, then differentiating between a hedging transaction and a speculative trade can become very complicated; if the impact of the underlying exposure is opaque, then the risk-reducing impact of the hedge becomes obscured (if it ever existed). This appears to be one of the problems in the JP Morgan case; because the hedge was aimed at the firm’s “overall credit exposure”, it was very difficult to match the effects of the hedge (determined by the value of specific hedging instruments, in this case credit derivatives) with the underlying exposure, which was driven by numerous variables, including the macroeconomic environment as a whole, and the performance of the specific corporate loans. The weaker the relationship between the hedge and the underlying exposure, the easier it will be for hedging activity to be mistaken for, or transformed into, speculative trading.
A third factor which points to the blurred lines which often exist between hedging and speculation relates to the use of both linear and nonlinear derivatives (i.e. forwards and options) to hedge known exposures (using options to hedge uncertain exposures is not really evidence of speculation, as much as sensible hedging policy). The corporate use of more complex structured products, whose main purpose is to ‘outperform’ the market under certain expected market conditions, within corporate hedging programmes, is perhaps the best evidence that hedging and speculation are closely related. The definition of speculation, according to the Merriam-Webster dictionary, is “assumption of unusual business risk in hopes of obtaining commensurate gain”. Using complex structured products, which incorporate exotic characteristics such as barriers, knock-outs and extendible features, to hedge a simple forecasted future exposure, surely meets this definition.
On one level (at the extremes), there is no doubt that hedging and speculation are very different activities. However, once you move beyond the straightforward elimination of open positions, into more nuanced transactions involving complex hedging strategies or tenuous relationships between hedges and exposures, the distinction between a hedge and a bet becomes increasingly vague. To quote Mr. Dimon, it is important that we “understand the need of rules and practices to ensure that hedging doesn’t morph into something different.” The acknowledgment that hedging and speculation are often different points on the same spectrum is a good first step in ensuring that this advice is followed.