P1.Chap2 - Why is earnings increase a "con" for hedging?

[coffee_achiever]

The video states that one downside of hedging is "Tradeoff between economics and accounting: reduced cash flow volatility may increase earnings". I don't really understand the statement very well:

• Reduced volatility may also decrease earnings (think about an OTM option close to expiry).
• How is increased earnings a downside?
• Not sure what economics vs accounting means and the video doesn't quite explain it.

 

[Clay Carter]

The video states that one downside of hedging is "Tradeoff between economics and accounting: reduced cash flow volatility may increase earnings". I don't really understand the statement very well:

• Reduced volatility may also decrease earnings (think about an OTM option close to expiry).
• How is increased earnings a downside?
• Not sure what economics vs accounting means and the video doesn't quite explain it.

@coffee_achiever I don't know everything about the video off the top of my head but I hope what I wrote below helps and let me know if you have more specific questions.

• Reduced volatility may also decrease earnings (think about an OTM option close to expiry).

Think about an out-of-the-money option that’s close to expiring. If the market doesn’t move enough, the option expires worthless. You paid a premium for it, so that cost hits your earnings, even though nothing "bad" happened. From a risk management perspective, you did the right thing by protecting against downside but from an earnings perspective, you’re down the cost of the hedge, and that can make your income look lower than it would’ve been without it. So yeah, reducing volatility doesn’t always mean better earnings, in fact, sometimes it means giving up potential upside.

• How is increased earnings a downside?

Let’s say you use a hedge that smooths out your reported earnings because of how the accounting rules work. Your income statement looks great maybe even higher than expected but the real economics haven’t changed much. If investors or managers misread that and think performance has improved when it’s really just an accounting effect, that can be risky. It could lead to overconfidence, bad decisions, or missed warning signs. So the problem isn’t higher earnings by themselves it’s that they can sometimes give a false sense of security if they don’t reflect what’s actually happening under the surface.

An example I always use here is think of a pharmaceutical company that cuts $2B this year from R&D. That can really help earnings but its at the cost of future projects.

• Not sure what economics vs accounting means and the video doesn't quite explain it.

Economically, a hedge might be great it protects your cash flow or locks in costs. But depending on the accounting rules, you might still show gains or losses on your income statement that make things look volatile. Or the opposite you might show smooth earnings even if your risk hasn’t changed. That’s the disconnect. So this tradeoff is really about how the numbers we report don’t always tell the full story about the risks a company is managing.

Hope this helps but let me know if anything doesn't make sense or isn't what you meant! CC