The World Bank this past week announced the creation of The Agriculture Price Risk Management (APRM) tool, jointly offered by the IFC, the World Bank Group’s private sector arm, and J.P. Morgan. The IFC and J.P. Morgan will each commit approximately $200 million in guarantees and letters of credit to enhance the collateral required from farmers, food processors and consumers in developing countries, to enable these groups to trade derivatives that hedge the price of commodities such as corn, wheat, soybean, rice, sugar, cocoa, milk and live cattle.
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Commodities markets have been quite agitated in May. The tremors felt on May 5 have not dissipated and recent data on the US economy, the risks of inflation in China’s and the protracted debt crisis in the EU left many traders wary. Prices of precious metals, industrial metals and oil have all dropped. So far, grains, led by corn, have held their value pretty well.
Corn is now being planted to be harvested in August. Weather is the main factor affecting the progress of planting and yields (#bushels per acre), and consequently a key driver of prices for new corn. Estimates indicate that the planting season is behind schedule, and that flooding of the Mississippi has destroyed some fields. Lower expected yields and acreage put further strains on an already historically tight ratio of stocks-to-usage – a measure of supply and demand.
Presumably these facts should have a greater impact on the incoming crop season (new corn). Yet, the recent sharp rally in corn prices occurred in nearby contracts (July futures) rather than in December futures contracts. Why is old corn more bullish than new corn?
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April 10, 2011 – 12:41 pm
In an article in the Financial Times this week, Patrick Honohan, Governor of the Central Bank of Ireland, proposes that Irish debt repayments be linked to the country’s growth:
“One dimension which, in my personal view, has not yet received the attention it deserves is the potential for mutually beneficial risk-sharing mechanisms. A variety of financial engineering options could be considered going beyond the plain vanilla bonds currently employed.
A simple version, which could indeed be useful beyond the specific case of Ireland, would, over time, shape the arrangements with European partners in such a way that Ireland pays more if its GNP growth is strong; less and slower if growth remains weak. The aim of such GNP-linked bonds or similar risk-sharing innovations must be to restore, through growth, a favourable dynamic to the sovereign debt ratio, putting its sustainability too, like that of the banks, beyond doubt.”
After a sharp decline in GNP per capita that put Ireland back a decade, Patrick Honohan is worried that the downward cycle of debt overhang and austerity measures will further erode growth and make debt even more burdensome. Continue reading →
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Yale’s Robert Shiller used his occasional Sunday New York Times column this week to dive deeper into the risk sharing issues at hand in the debate about public employee pensions. As I mentioned in a previous post, the idea of pensions as a risk sharing device is probably a fruitful line to pursue. Shiller hardly moves the ball, but the mere fact that someone of his stature and insight picked it up at all is encouraging.
En route, Shiller mentions a paper by Henning Bohn of UC Santa Barbara. Two things to note about that paper… First, it’s less about risk sharing and more about arbitraging financial frictions. I suppose the two are closely related, but they sure sounds distinct. Second, and more importantly, Bohn’s paper is about the right level of funding for pension plans, and in no way takes a stand on the right valuation of the existing liabilities. Bohn’s claim is something like this: one should underfund a $100 liability by putting aside only $60. But even if you give him this point, that isn’t the same thing as saying that at $60 the pension is fully funded. The liability is still $100, and Bohn’s paper doesn’t contest that. He’s just saying it’s ok to underfund. As mentioned in my earlier post, these are two distinct points.
Shiller ends the column with a plug for an idea he has been hawking for a while, GDP linked bonds. The idea sounds exactly right. But it hasn’t taken off–yet. Perhaps it will soon. Or perhaps the mechanics are just infinitely more difficult than it sounds like at first. Pensions and risk sharing and financial innovation are a hugely complex topic. The time scales are long and the actors involved encompass the whole body politic–born and yet to be born. Moreover, the issues to be settled are so vast that it is difficult to imagine any narrowly crafted contract — and all financial contracts are narrowly crafted, unlike a ‘social’ contract — could adequately express and delineate whatever consensus was achieved. This is where an attempt to address the problem from a purely technocratic, financial perspective, as Shiller’s proposed GDP bonds purport to do, is bound to miss the mark by a mile.
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March 10, 2011 – 12:41 pm
Exxon doesn’t use derivatives. At least not many of them. This is in strong contrast with a number of other oil majors that make active use of derivatives—for example, BP and Shell.
This fact is a real puzzle for those who argue that companies should use derivatives to hedge the financial risks coming from their physical business. Since we are among the advocates of hedging, we take the puzzle seriously. We’ll come back to that shortly.
This fact also stands as a rebuke to some of the opponents of reforming the OTC derivatives markets who misrepresent the connection between derivatives trading and the physical business of many end-user companies. More on that later, too.
First, the numbers. Although it is well known within the industry that Exxon avoids using derivatives, it’s nevertheless worthwhile to see how this fact is manifested in the reported financial statements. Here’s a condensed version of Exxon’s 2009 balance sheet with the derivative portion highlighted:
The net derivatives position equals approximately 4 one-thousandths of 1% of Exxon’s equity. [One has to be cautious about using a net liability figure, since this can underestimate the significance of the derivatives position. But our understanding of US accounting rules (aided by unnamed sources with actual knowledge of accounting) is that if the gross positions had been material, Exxon would have had to disclose them. That, plus other knowledge of Exxon, leads us to believe this net figure is probably not misleading.]
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February 9, 2011 – 10:47 am
NPR ran a story this week on how airlines and other business are using futures contracts on snowfall “as a type of insurance policy against the weather.”
Weather derivatives can be a useful instrument for hedging, and hedging is a kind of insurance policy. But it is useful to keep in mind how a futures contract is different from an actual insurance policy.
A futures contract is written on a very specific commodity price or other well specified index. The snowfall futures contract is based on measured snowfall at a given location–such as Chicago’s O’Hare Airport–within a given month. It has a payoff that is very mechanically tied to that index. If snowfall impacts an airline’s business by cutting into revenues from flights, then buying a futures contract on the amount of snowfall may help reduce the total volatility of cashflow.
The catch is that the correlation between the loss of business and the amount of snowfall is imperfect. The futures contract doesn’t payout the amount of an airline’s losses. It’s payout is determined by the index, and the index isn’t always a good signal of the airline’s losses. The number of flights canceled is likely to be greater if the snow is concentrated in a couple of heavy storms than if it is spread out evenly throughout the month. But the futures contract payout will be the same in both cases. Similarly, two storms with comparable snowfall may have very different impacts on the complicated network of flights:
This is where insurance policies have an advantage. When I have an automobile accident, my insurance company covers the damage, whatever the damage–less my deductible. If snowfall causes roof damage to my house, my homeowner’s insurance covers the repairs. It doesn’t make the payout contingent upon total snowfall in the month, regardless of whether I have any damage or not. The payout is contingent on the scale of the damage. When hurricane Andrew struck Florida in 1992, causing enormous damage, it was the scale of the damage actually done that caused the large insurance payouts, not the measure of windspeed or quantity of rainfall. A hedging strategy using futures contracts doesn’t have this flexibility to make the payout contingent on the actual losses incurred. This is another example of basis risk.
Of course, in order for insurance contracts to offer this extra benefit of making the payout match the loss, they have to hire adjusters to investigate claims. Obviously there is room for a disagreement between me and my insurer over whether my auto or home claim is really covered by my contract and reimbursable, and what is the actual size of the loss. This distinctive feature of insurance–that the payout is directly tied to the amount of damage–is a costly feature. The transactions costs–in the form of adjusters, appraisals and disputes–are high. Futures contracts have low transactions costs by making the payout contingent on an easily measured index. But the tradeoff is that a payout linked to this index doesn’t quite match the losses.
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February 3, 2011 – 8:15 am
Bloomberg had a news article earlier this week that highlights the practical problem of implementing a hedging strategy even in one of the largest commodity markets, jet fuel. Many airlines attempt to hedge some portion of the anticipated cost of jet fuel purchases over the coming year. In large part, they do this by purchasing futures contracts on either crude oil, the feedstock for producing jet fuel, or heating oil, another refined product that is slightly different from jet fuel. The prices of the three commodities are correlated, but only imperfectly. In the long run, if the price of crude oil goes up significantly, the price of the refined products must also go up. But in the short run, the relationship is very erratic. The price of crude and jet fuel can even sometimes move in opposite directions as they have recently. Here is a graph of the crack spread over the last number of years:
The spread graphed is the difference between the price of the refined products produced from a barrel of oil and the price of the barrel of oil. The graph shows the most widely quoted version of the crack spread, the 3:2:1 spread–i.e., 3 barrels of crude oil yields 2 barrels of gasoline and 1 barrel of heating oil. Clearly this spread swings significantly through time.
This is a classic case of basis risk, which is just the volatility in the differential between two related commodities or between one commodity for delivery at different locations or different delivery dates. Basis risk undermines the effectiveness of a hedge built using a related commodity. Airlines that used crude oil futures to hedge their jet fuel prices are finding that the hedges are losing money at the very same time that jet fuel prices are going up. This is exacerbating the cash flow volatility that the hedge is designed to reduce.
What can be done about this? Continue reading →
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January 15, 2011 – 11:53 am
A new academic research paper by Campello, Lin, Ma and Zou takes a stab at documenting the impact of corporate hedging on the terms at which the company can borrow money in the syndicated loan market. (older version available here for free) For the last two decades, syndicated loans have been the largest source of funding for corporations, larger than the bond issuances. The study looks at hedging and loans at 1200 firms over the years 1996-2002. The authors advertise the paper as a look at one important channel through which hedging may add value to companies.
The findings are…
1. Increased hedging lowers the loan spread.
Companies with average usage of hedging derivatives are charged loan spreads that are 28% lower than non-hedgers. The impact is stronger for companies with higher probability of bankruptcy (lower Z-scores) and for companies with higher growth opportunities (higher market-to-book ratio).
2. Increased hedging lowers the probability that a loan will include a covenant restriction on investments.
An average hedger has 20% less probability of facing investment restrictions than a non-hedger. In addition, a one-standard deviation drop in Z-score increases the likelihood that the lender will impose a capital expenditure restriction on a non-hedger by 15.5%, compared to a statistically insignificant 5.2% for a hedger.
3. Increased hedging increases investment spending by 13% over the mean level.
Three comments.
First, while the paper’s results are surely important, the discussion of the impact on firm value is very confused. For example, an effort is made to decompose the portion of the loan spread that reflects an adjustment in the nominal rate in order to compensate for the expected loss of default, and the portion that equals the true economic rate of return. The authors label this latter variable the “true cost of debt”. But it is not a deadweight cost, so whether hedging reduces this true cost or not does not answer the question of whether hedging raises the value of the firm. Assuming a Modigliani-Miller world, hedging lowers the systematic risk of the firm and therefore its expected return on capital. The return on debt will fall, accordingly. But this leaves firm value unchanged. We can abandon the Modigliani-Miller assumption and recognize that hedging may somehow reduce deadweight costs and therefore does increase firm value. But still, this reduction in deadweight cost isn’t measured by the authors’ “true cost of debt” variable.
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January 5, 2011 – 11:11 am
Reuters’ Breakingviews has a column suggesting that a number of corporates are issuing floating rate debt in order to service the demand of investors for an inflation hedge. Recent issuers mentioned are Berkshire Hathaway, General Electric and MetLife. The column is entirely conjectural on whether this is the actual motivation of these companies. And the column makes much of a tiny sample and short window. But…
There is very good evidence that companies are more likely to choose a floating rate issue over fixed when the yield curve is steep as it is today and has been for a while. The recent literature began with a paper by Michael Faulkender (now at UMaryland) in the Journal of Finance. There has been a long stream following that. Faulkender studied issuance by companies in the chemical industry and found:
(i) their exposure to interest rates did not predict their choice of floating vs. fixed interest rate debt — i.e., hedging needs did not drive the choice, and
(ii) the price of interest rate risk did not predict their choice –i.e., they were not selling the highest value security.
Instead, the companies appeared to be choosing floating vs. fixed in order to:
(a) manage earnings, or
(b) ride the yield curve, a familiar and dubious speculative strategy.
The Reuters conjecture that corporates are giving bond investors the inflation hedge they deserve is at odds with Faulkender’s results. It matches explanation (ii) above, which the data did not support. In my mind, Faulkender’s results are very weak on (ii) because it is very hard to measure this sort of thing. So perhaps these issuers are providing the market something it demands. Right now, however, there is little substantive evidence in favor of the Reuters conjecture and good evidence that company financial officers have all the wrong incentives and are insufficiently monitored and disciplined for gambling on interest rates.
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November 26, 2010 – 2:20 pm
In an earlier post we discussed one of several reasons why companies tend to focus their hedges on short-term cash flows, leaving long-term cash flows unhedged. There we pointed out that the right response over the long-run to fluctuating prices and other risk factors, is changes in the operations and investments of the firm in order to re-maximize profits in light of the new competitive conditions. But there are several distinct reasons for the practice, and that was only one of them.
Another reason why firms concentrate their financial hedges on short term cash flows has to do with uncertainty about the nature of the exposure at longer time horizons. Competitive exposures are very complicated, and involve many, many risk factors. We oftentimes focus on a single specific risk factor and quantify the exposure in very simplistic models. This is necessary if we are going to implement a financial hedge. For example, the airline needs to buy or sell futures contracts on a specific type of fuel delivered at a specific location on a specific date. To design that hedge we try to quantify the airline’s exposure measured in terms of the commodity represented by that specific fuel. But this focus on a single risk factor and exposure measured using recent data is only valid for very short horizons. The correlation between the futures price for that specific fuel and the airline’s actual cash flow may not hold at some distant date. All sorts of changes could undermine the validity of extrapolating that correlation. Some of these may be changes in the industry’s competitive dynamics, some may be in the types of fuels that are used by the airlines. For example, if bio-fuels gradually replace fossil-based fuels in jets, then the correlation between crude oil prices and the airline’s exposure will almost certainly change. The higher the uncertainty about the industry dynamics, the less a firm should commit to hedge, because it knows less how much it should hedge. And the essence of uncertainty is that it increases just with the length of time into the future. Prudence (i.e., sound risk management) indicates that it is not right to make commitments – either firm or contingent – when ignorance pervades.
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Betting the Business 
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