Trade-offs are inescapable with derivatives. For instance, when hedging with futures, forwards or swaps, no initial payment is required to initiate the contract, but users have to be willing to forgo the benefit of advantageous price moves in order to be protected from adverse moves. When buying options, caps or floors on the other hand, users have to be willing to bear upfront payments in the form of option premiums to secure the prospective benefits, appreciating that some or all option premiums will be realized costs, irrespective of whether those instruments subsequently pay off or not.

Entering into any hedging contract requires a secondary determination beyond simply recognizing which price change direction would be adverse. That is, when locking in a price, the anticipated effective price (post hedge) is critical. It’s not enough to lock in any price. For hedging to be desirable or appropriate, the price that the market allows you to lock in has to be an acceptable price. Prospective buyers wouldn’t want to look in a price that is too high, and prospective sellers wouldn’t want to lock in a price that is too low. Similarly, if using a purchased option, cap or floor, that contract would have to be cheap enough. Put another way, at some sufficiently high premium, the protection gained wouldn’t be worth the price paid.

The preference for futures, forwards, or swaps over options because the former contracts require no initial upfront expense is shortsighted—at least to some extent. Using the nomenclature of economists, futures, forwards, and swaps inherently bear opportunity costs, reflecting the fact that users must forgo the effects of a beneficial price moves. These opportunity costs would be unknown at the start of the contract, but they could end up being considerable if and when the price of the exposure being hedged moves sharply. In contrast, for options, caps and floors, maximum costs are explicitly known at the start of the hedge, equal to the premiums paid. With this foundation, it should be clear that the choice between using futures, forwards or swaps on one hand, and options, caps or floors, on the other, should compare potential opportunity costs of the former with known upfront premium amounts of the later.

Subjectivity required

So when is a fixed price acceptable, and when is an option price cheap enough? Unfortunately, these judgments involve some subjectivity. That subjectivity notwithstanding, for futures, forwards and swaps, the choice for the prospective hedger distills to choosing between taking the fixed price dictated by that contract or maintaining the exposure and hoping that the unhedged prices will end up yielding a better outcome. Clearly, different players with different risk tolerances and different market expectations will make different choices under the same market conditions.

For entities evaluating the purchase of options, caps and floors, the alternatives are to bear the unprotected risk and hope prices won’t move (too) adversely, or to pay some known premium to offset the effects of prices rising above or below a critical threshold. With options, caps and floors, though, choices abound, in that you can structure a hedge with any budget in mind, recognizing that paying a higher premium expands the range of prices for which protection will apply. Put another way, the cheaper the option, the greater the price risk borne by the hedging entity.

Entering into a hedge is, in effect, a pricing decision; so, too, is the decision not to enter a hedge. Not hedging implies a judgment that the expected unhedged outcome is expected to be preferred to that which would arise if a hedge were in place. From that perspective, a chronic posture of not hedging known exposures would seem to be an abrogation of fiduciary responsibility. Surely, some situations must occur from time to time, where the terms of hedging derivatives are particularly advantageous, but you have to assess the markets on an ongoing basis to see if and when those circumstances arise.

Three observations:

• Hedging should not be thought of as an all-or-nothing proposition. The more attractive the fixed price of a derivative or the price of the option, the more desirable the hedge. Thus, it may be reasonable to hedge larger portions of risk exposures with more attractive derivative pricing, and a smaller portions with less attractive derivatives pricing. Moreover, the degree of hedge coverage deserves to be reconsidered on an ongoing basis as time passes and as market conditions change. Hedging entities should be comfortable about taking a partial coverage as a starting posture, with the idea of adjusting that coverage (upward or downward) over time.

• Forward prices are reflected in the pricing of all derivatives, and they are what they are. Thus, there’s no way to recoup any seeming adverse difference from today’s spot price. The only thing a derivative can do is protect from further adverse price changes than those already reflected in the derivative’s starting price.

• The relationship between spot and forward prices may provide a seeming advantage to one side of the market relative to the other. For example, when forward prices are markedly higher than spot prices, prospective sellers are able to lock in seemingly high sales prices. Conversely, when forward prices are markedly lower than spot prices, prospective buyers can lock in seemingly low purchase prices. Forward prices at comparable levels to current, spot prices would thus seem to offer a fairly neutral setting for hedgers, favoring neither buyers nor sellers.

Reach Ira Kawaller, founder of Kawaller & Co., at [email protected].
A longer version of this article appears in the latest edition of AFP Exchange