And Now For Something Completely Different*: When A Hedge Isn't

July 26, 2012

The verb form of the term hedge dates back at least to the 16th century. In Shakespeare’s The Merry Wives of Windsor, Sir John Falstaff said, “I, I, I myself sometimes, leaving the fear of God on the left hand and hiding mine honour in my necessity, am fair to shuffle, to hedge and to lurch.” Falstaff was a vain, overweight, drunken liar. So it’s no surprise that he would equivocate.

 

The term was first used in financial transactions, in the early 17th century, when “hedging one’s debts” referred to a loan secured by inclusion in a larger loan. The more familiar “hedging one’s bets” came into usage somewhat later when bookies of the day laid off a bet by taking out smaller bets with others to avoid going broke to pay off the original larger debt.

 

All of this came to mind when we took notice of the debate about whether J.P. Morgan’s much publicized trading loss, reported to be somewhere in the billions of dollars, could possibly be, as the bank claimed, attributed to a hedge gone wrong. At the risk of over simplifying it, the trade basically consisted of the bank’s selling a CDS index as a form of insurance which depended on the stability of the corporate bond market.

 

So the question is, what’s a hedge? And how much does the definition really matter?

In the most general sense, a hedge is an investment undertaken to limit the risk of another investment. But hedging is by no means confined to the world of investments. One can hedge a long position with put options or by buying insurance to limit the risk of injury. Insurance after all is nothing more than put writing in inefficient markets.

 

Other more technical, and more complicated, definitions govern where the existence of a hedge has regulatory significance. For example, the Commodity Futures Trading Commission exempts hedges from position limits for derivatives. To qualify, a transaction must be economically appropriate for the reduction of risk in a business and satisfy a number of additional requirements.1

 

And transactions in commodity futures, even if only partially designed to protect against principal risk for a business, are incident to the everyday operation of the business. Such hedges therefore give rise to ordinary income, or ordinary deductions, and are not entitled to capital gains treatment.2 So whether a transaction is a hedge does have practical consequences.

 

These consequences and the definition of a hedge only confirm what we already know about the nature of hedging. A hedge protects to some degree against a risk of some sort, and you need to know about the underlying facts to determine what is a hedge and what isn’t.

 

One characteristic of a hedge is its liquidity or at least a limit on the downside. To a large investor with large positions, the problem of maintaining a comparatively liquid hedge is particularly acute.

 

But back to J.P. Morgan. The bank’s CDS positions are relatively illiquid. It does not yet know the extent of the losses. Still, J.P. Morgan’s claim that the position was a hedge, at least at the outset, is hard to refute. A bank that big has so many profit centers and positions on its book, that any transaction is conceivably a hedge.

 

Maybe you already know this. But what starts out as a hedge turns into something else‑‑say, a bad investment–when it gets to be bigger than the position it was supposed to be hedging, moves the market and, most importantly of all, winds up causing the investor to lose a lot of money without a more than offsetting profit in the primary position elsewhere.

 

* Used without permission of Monty Python.

  1. 17 C.F.R. §1.3(z).

  2. Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955).

 

 

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