36 The Management of Bond Investments and Trading of Debt
As we will see in section 2.5, one of the first principles for understanding and fol-
lowing a hedging strategy is to be prepared and to be selective. We do not need to
hedge everything. For instance, some oil companies protect themselves against swings
in interest rates and currencies, but not in petroleum prices. Others, however, design
their hedging program in a way to match their prevailing production profile a year or
two forward.
2.5 Upside and downside of hedging
Some of the people I spoke to in my research suggested that accounting for gains and
losses currently associated with hedges is incomplete and possibly misleading. While
this observation is correct, it is beyond doubt that the first requirement in a hedging
strategy is understanding of the instrument(s) to be used and of procedures associated
to it (them). Any effective hedging policy rests on four pillars:
Knowing what we want to do
Understanding what we are doing
Having systems to support our policy, and
Making sure the senior management is in charge.
This is true of debt markets, equity markets, and macro-markets, but most particu-
larly of the junction of debt markets and macro-markets because the two together get
more easily superleveraged – and therefore, engender greater risk.
Moreover, hedging-related accounting should provide timely and accurate informa-
tion for management, enriched with hedging-related disclosure. This should be done
in a transparent manner (see section 2.6), enabling investors, creditors, government
supervisors, and other users of financial statements to appreciate:
An entity’s risk exposure, and
Its strategy for risk control.
To provide the reader with the holistic aspect of transparency requirements, Figure 2.2
gives a bird’s-eye view of players contributing to production and distribution of reliable
financial reports.
Alongside companies active in debt trading, hedging through complex transactions
requires appropriate disclosures of the transactions themselves and of the instruments
used to hedge anticipated moves, like compensation for assumed risks through deriva-
tive financial instruments. As for senior management’s understanding of what hedging
is supposed to do, and the risks it involves, this should include:
The period of time of firmly projected future financial action, and
The amount to hedging gains and losses realized, as well as explicitly deferred.
Trading debt in a globalized economy 37
PUBLIC COMPANY
OVERSIGHT OF FINANCIAL REPORTING REQUIREMENTS
SECURITIES AND EXCHANGE COMMISSION
FINANCIAL INSTITUTIONS' REGULATORY AGENCIES
(FED, FDIC, OCC, OTS, STATE AUTHORITIES)
FINANCIAL ACCOUNTING STANDARDS BOARD
ACCOUNTING AND AUDITING PROFESSIONALS
COURTS AND COURTS OF APPEAL
INDEPENDENT PUBLIC ACCOUNTANT
FINANCIAL REPORTS
USER OF FINANCIAL INFORMATION
Figure 2.2 Players contributing to the production and distribution of reliable
financial reports
Just as necessary is a description of transactions or other events that result in the
recognition of gains or losses deferred by hedge accounting. This is not common
policy, both because only recently has regulation begun looking into future gains
and losses, and because few bankers, treasurers, traders, and investors take care to
distinguish between speculating and hedging.
There exist, however, positive examples. In terms of currency exchange policy, for
instance, some companies like Bechtel Corporation, the global engineering group,
sometimes arrange to be paid in a basket of currencies that mirrors what they must
lay out to cover costs. And in regard to interest rates, some companies guard against
sudden spikes in currency exchange by hedging the maturities of their debt.
Sometimes management takes hedges by means of diversification outside the com-
pany’s main business, but these hedges can turn sour. In the late 1970s/early 1980s,
Merrill Lynch went into real estate brokerage, but lost money. In 1966, Nomura
Securities was placed on Standard & Poor’s CreditWatch list (with negative implications)
after it said it would provide 371 billion yen ($3.39 billion) to help its Nomura Finance
unit deal with bad real estate loans.
In other cases, the board micro-manages a hedge – doing so without allocating
appropriate time, or even skill. Then a market gyration turns the hedge on its head.
In late 1995, after the dollar’s turnaround against the yen, Hirokazu Nakamura,
chairman of Mitsubishi Motors, said that when the yen passed the 100 bar to the US
dollar his company lost a torrent of money. Mitsubishi had hedged at 90 yen to the
dollar, until 31 March 1996.
5
Prognostication accounts for a great deal in the art of hedging, and market prog-
nostication is a tough business. Therefore, while the calculations leading to a hedge
may be sound and the hedge can initially work, as the market changes a hedge may
become counterproductive.

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