Contemplate this scenario: Lend money to New York homeowners; Bet against the New York Yankees. Is this a "hedge"?
We all know the adage: Figures don't lie but liars figure.
Take J.P. Morgan Chase's recent $2 billion plus loss, which has been described as a hedge. The frequency with which pundits have asserted that "hedging" and "speculating" or "betting" are hard to distinguish is nauseating. Adoption of the "Volcker rule" has been delayed by this canard.
I grew into the financial world with no such view, convenient as it can be at times. Here is what I was told: A "hedge" is a transaction entered to generate gain from the same event that would hurt my existing commercial operations, allowing recoupment of some of those losses.
A "speculation/bet" is a transaction subjecting one to the risk of loss from an event over which one has no effective control, easily avoidable and deliberately assumed in the hope of profiting if the event does not occur. The basics of futures markets — the reason they were allowed to exist instead of being banned as gambling — is the fact that hedgers transfer risk to speculators. Hedgers use markets to reduce risk, speculators facilitate this thus it is not gambling and is legal.
A "good" hedge involves taking a position that is HIGHLY correlated with (but opposite) the hedger's existing exposure. A farmer sells corn futures just in case of a harvest glut that drives real corn prices lower. (A farmer is naturally long corn in the future). A crude oil producer sells crude oil futures against the prospect that abundant supplies or dwindling demand for by-products depresses resale prices. In each case, the hedge is likely to track prices for the same or a nearly identical product: a $1 commercial loss should generate roughly a $1 hedging profit.
Today, many "hedges" do not correlate nearly this well. The use of "macro hedges" based on a combination of potential events, only some of which relate to the user's actual commercial risks, are commonly employed. For example, a credit default swap based on an index of 100 securities may include only 10 or fewer securities actually owned by the user. If defaults occur among the other 90 or so, the user is safe but still may profit from the swap.
If there are better correlated alternatives, like options or swaps on the specific securities at risk, why not use them? They may cost more, of course, but hedging is an insurance system meant to protect. Is a cheaper, less expensive policy justifiable if its effectiveness is doubtful?
So, what does this have to do with the Yankees? Suppose someone ran the numbers and seemed to find a vague correlation between the club's success and the general well-being of New Yorkers or some correlation between a bad season and a local economic slump that could lead to mortgage defaults. Is this a good hedge?
Regulators might benefit from restricting "hedging" to HIGH CORRELATION offset transactions. Hedgers, to qualify as such, would need to affirmatively show that the positions are either the ONLY or the BEST way to manage their risk. And anyone who chooses to use a cheaper, less effective strategy should raise doubts about whether they are really managing risks at all.