HEDGING PROGRAMMES
Box 1: Demystifying Derivatives Instruments With Risk Education
In today’s volatile environment, it is imperative that economic policymakers develop an understanding of the impact of energy and commodity price changes in macroeconomic activity and ways to mitigate those exposures.
Despite the high potential costs of inaction, it is not surprising that those that lack basic understanding of derivatives often oppose hedging programmes or become highly critical if there is a negative outcome.
For example, after Ecuador suffered a derivatives $20 million loss in 1993, a committee was created to investigate ‘allegations of corruption’ against the central bank president. Nearly 20 years later, Ecuador has started looking into hedging its oil revenues again, which now represent around 24% of the overall budget.
Designing and executing a hedging programme may be complex and expensive, and in some instances, it may be optimal to outsource the execution of the hedging programme to a third party such an investment bank or large energy marketer. But even in those instances, the programme’s key objectives and constraints should be defined by the policy makers, not the advisors.
objectives of the hedging programme with its tactical execution. The policy should address the volumes and time horizon of the hedge programme, instruments allowed and amount of funds available to purchase protection.
4. Set up a truly independent unit to execute the hedging strategy with minimal political interference. Ensure that the unit has the necessary authority, experienced staff, stature and adequate resources to fulfil their responsibilities. Risk managers can analyse alternative strategies, acquire market information, network with potential counterparties, and report on the evolution on the programme.
5. Do not rely on counterparties for hedging advice. Counterparties are necessary to execute some hedging programmes outside the organized exchanges, but their main goal is to maximize profits, not provide ‘unbiased’ hedging advice. Beware of counterparties offering trading advice and complex structured products.
Risk Dimensions Hedging decisions can be complex and should be
approached carefully and methodically within an appropriate decision-making framework. Evaluating hedging strategies requires a multi- disciplinary approach to ensure that risk/return trade-offs under different scenarios are well understood and communicated up-front. The analysis could include areas such as the impact on economic policy as well as the likely reaction from various stakeholders (constituents, rating agencies, creditors …) and the potential political fallout if there are substantial hedging losses. The only iron clad certainty with a hedging
programme – or the lack of one – is that some stakeholders will be unhappy with the outcome
once the results are known. When governments are evaluating alternative hedging programmes, one of the main issues is how to deal with the potential regret if there are hedging losses, particularly if they are large. Empirical studies have shown that as a rule of
thumb, the pain associated with losses is twice as large as the pleasure associated with gains. It is reasonable to expect that effect even more amplified by the financial press and opposition parties in the event of a large hedging loss as critics come out of the woodwork questioning the decision and demanding the hedge programme be discontinued.
The only iron clad certainty with a hedging programme – or the lack of one – is that some stakeholders will be unhappy with the outcome
Therefore, effective communication of the hedging policy and the benchmarks that will be used to determine its performance are critical for the long term success of any hedging strategy. A series of key risk indicators or KRIs that reflect the key variables impacting the hedging decision can assist in the process of evaluating trade-offs and also set hedge performance benchmarks. A properly designed hedge strategy that addresses
regret risk, and mitigates it by adding inexpensive options is more likely to succeed in the long term.
Media Coverage & Active Communication Every hedging programme will eventually
experience worse than expected results, so governments should be ready to defend the decision to hedge and minimize the impact of negative media coverage. To avoid other people creating a story around the
outcome of the hedge strategy on a given period, December 2012
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