Can this be elaborated with example?
Disadvantage of hedging risk
- Thread starter [email protected]
- Start date
Can this be elaborated with example?
Hi if i may add my two cents,
Consider an oil producer firm which is prone to oil price changes that increases variability in true economic value of firm due to variability in oil prices as value of firm is governed solely by future oil prices. Now if we hedge oil prices using forwards/futures and firm agree to sell at fixed oil price that will reduce the variability of firm's economic value as now there is no variability in oil prices.
The gap b/w accounting earnings and actual cash flows shall increase because of hedging. In accounting earnings we are considering actual mkt oil prices which shall not reconcile with the net oil price in cash flows which considers hedging also. The use of actual mkt oil prices shall increase the variability of earnings even when you hedge but hedging do reduce variability of cash flows. Therefore main point above is that hedging shall reduce variability of firm economic value but accounting earnings are still prone to variability becacause of gap created by hedging. If hedging was not there gap would not have been created at the first place and both accounting earnings and economic cash flows shall show same level of variability.
Consider an oil producer firm which is prone to oil price changes that increases variability in true economic value of firm due to variability in oil prices as value of firm is governed solely by future oil prices. Now if we hedge oil prices using forwards/futures and firm agree to sell at fixed oil price that will reduce the variability of firm's economic value as now there is no variability in oil prices.
The gap b/w accounting earnings and actual cash flows shall increase because of hedging. In accounting earnings we are considering actual mkt oil prices which shall not reconcile with the net oil price in cash flows which considers hedging also. The use of actual mkt oil prices shall increase the variability of earnings even when you hedge but hedging do reduce variability of cash flows. Therefore main point above is that hedging shall reduce variability of firm economic value but accounting earnings are still prone to variability becacause of gap created by hedging. If hedging was not there gap would not have been created at the first place and both accounting earnings and economic cash flows shall show same level of variability.
Last edited:
Hi @ShaktiRathore
I don't understand the following:
"In accounting earnings we are considering actual mkt oil prices which shall not reconcile with the net oil price in cash flows which considers hedging also."
I agree that accounting would consider actual market prices for oil. But wouldn't accounting consider the mark-to-market gain/losses of futures / options as well? In your example you say that we want to hedge the variability of oil prices. In that case we would go short oil futures thereby locking in a certain price. If oil prices rise, we can sell our oil for more but loose on the short future position and vice versa.
This way I would assume we nullify any variability (apart from basis risk).
Where's the flaw in my thinking?
thanks,
Roland
I don't understand the following:
"In accounting earnings we are considering actual mkt oil prices which shall not reconcile with the net oil price in cash flows which considers hedging also."
I agree that accounting would consider actual market prices for oil. But wouldn't accounting consider the mark-to-market gain/losses of futures / options as well? In your example you say that we want to hedge the variability of oil prices. In that case we would go short oil futures thereby locking in a certain price. If oil prices rise, we can sell our oil for more but loose on the short future position and vice versa.
This way I would assume we nullify any variability (apart from basis risk).
Where's the flaw in my thinking?
thanks,
Roland
Hi
According to my answer the accounting earnings do not consider hedging i.e gain and losses of futures/options, but cash flows do consider it. So accounting earnings which is not considering hedging shall reflect variability of oil prices but cash flows which considers hedging shall not reflect variability of oil prices,as u said nullifying variability.
Thanks
According to my answer the accounting earnings do not consider hedging i.e gain and losses of futures/options, but cash flows do consider it. So accounting earnings which is not considering hedging shall reflect variability of oil prices but cash flows which considers hedging shall not reflect variability of oil prices,as u said nullifying variability.
Thanks
Hi
I somehow still can't follow your argument. Why / when would accounting ignore hedging?
Being long oil and offsetting the variability of oil prices through derivatives (i.e. short future positions) would rather stabilize accounting earnings than leading to more variability.
On the other hand however I could see an increased variability in economic cash flows (I simply interpret economic cash flows as actual cash flows):
- Oil Price goes up
--> Accounting Gain on long position (no cash flow)
--> Accounting Loss on short position (likely cash flow due to margin call)
There would now be a gap between accounting gains of zero and negative cash flows due to margin call.
I somehow seem to miss something here..?
Thanks
I somehow still can't follow your argument. Why / when would accounting ignore hedging?
Being long oil and offsetting the variability of oil prices through derivatives (i.e. short future positions) would rather stabilize accounting earnings than leading to more variability.
On the other hand however I could see an increased variability in economic cash flows (I simply interpret economic cash flows as actual cash flows):
- Oil Price goes up
--> Accounting Gain on long position (no cash flow)
--> Accounting Loss on short position (likely cash flow due to margin call)
There would now be a gap between accounting gains of zero and negative cash flows due to margin call.
I somehow seem to miss something here..?
Thanks
Hi
If u consider forwards only instead of futures i think my point becomes more clear. If oil producer has monthly short forward contracts to sell oil at x then the variability of monthly oil prices is replaced with fixed cash flows of x which reduces variability of cash flows. In earnings the mkt price variability is still reflected if no hedging is considered there.
Thanks
If u consider forwards only instead of futures i think my point becomes more clear. If oil producer has monthly short forward contracts to sell oil at x then the variability of monthly oil prices is replaced with fixed cash flows of x which reduces variability of cash flows. In earnings the mkt price variability is still reflected if no hedging is considered there.
Thanks
Similar threads
