P1.T1. Help me understand how hedging is disadvantageous by reducing true economic value which ....

[MSO]

In Chapter 2 Corporate Risk Management notes, it is mentioned on page 23 of study material. Disadvantages of hedging risk "Hedging that reduces volatility in the true economic value of the firm could increase the firm’s earnings variability as transmitted to the equity markets through the firm’s accounting disclosures, due to the gap between accounting earnings and economic cash flows."

I am not able to follow the above para and how it translates to a disadvantage while hedging, can someone help me on this, please.

Would this mean accounting profits may increase/decrease because of the hedge, therefore, earning variability will increase, even though volatility in economic value is reduced, as an example - U.S. firm hedging a future sales order; which will lead to putting up hedge structure that will impact firm's P&L even though economic value is reduced because of the hedge.

 

[ShaktiRathore]

Hi,
Yes for e.g. if a firm sales X pound copper per year then the value of the firm(PV of the sales of copper) is fixed by hedging as the price at which the copper is sold is fixed through hedging therefore the economic value variability is reduced here through hedging,but the accounting earnings which take into account the profit and losses resulting from hedging can add to variability of these accounting earnings.

thanks

 

[David Harper CFA FRM]

@MSO as illustrated by @ShaktiRathore 's example, this disadvantage (which can be referred to as "hedge accounting", for example see https://en.wikipedia.org/wiki/Hedge_accounting) has recently been a public issue in accounting/financial statement analysis where the CFA institute has been involved (e.g., https://www.cfainstitute.org/learni...ons/commentletters/Pages/12162016_132766.aspx). The issue is accounting, and specifically IFRS 9 (https://en.wikipedia.org/wiki/IFRS_9). The "problem" in a super-nutshell is that a company might care primarily about its cash flow and long-term balance sheet and, by those accounts, the hedge instrument (which hedges an underlying exposure as the existence of a hedge always implies two positions, the exposure and the hedge) combined with the exposure should produce a relatively non-volatile combination. But as we've learned in many places, it can be hard to objectively distinguish between a hedge and speculation, so accounting has a test for whether a position qualifies as a hedge and principles that tend to want the losses on the hedge to be recognized immediately on the income statement.

So the company can end up in a situation where the combination (hedge + exposure) has a non-volatile impact on cash flow as a net combination, but the hedge is recognized as a current loss on the income statement (keep in mind, a properly designed hedge may have an expected loss by itself in the way that insurance has negative expected value) while, meanwhile, perhaps the exposure contributes a gain or maybe even nothing from a current period accounting perspective. The fact that they are separated in addition to the timing differences (current period) can create earnings (accounting) volatility.

It's thematic in accounting, actually, and transcends hedges: accounting has a noble job to do (informed by its principles), but the reported income statement has never been economic reality such that it was always the job of traditional financial analysts to "begin with" the reported financial statements and adjust them into economic reality (IMO). So, from my perspective, it is merely a trade-off not a problem and is only a "problem" if you believe the users of financial statements are generally naive and don't see through the face of the reported financial statement. I hope that's interesting, thanks,