Hedging at negative cost?

I have been reading the transcript of the conference call in which JPMorgan Chase reported a $2 billion loss on a position that was intended to hedge tail risk (h/t for the transcript to Deus Ex Macchiato). Much has been written about the hedge that JPM Chairman, Jamie Dimon, himself described as “a bad strategy ... badly executed ... poorly monitored.” I want to focus instead on another interesting statement that he made about the hedge:

It was there to deliver a positive result in a quite stressed environment and we feel we can do that and make some net income

Note the tense of that verb “feel”: he does not say “felt”, he says “feel” – after that $2 billion loss, he still thinks, that you can set up a hedge which makes money! The Chairman of one of the largest banks in the world – a bank which is still well respected for highly sophisticated risk management thinks that a tail risk hedge need not cost money, but can actually make money. In other words, there are negative cost hedges out there that can protect you against tail risk.

If you believe in the Efficient Markets Hypothesis (EMH), you know that this is not possible – there is no free lunch. Sure, you can hedge against tail risk, but that will cost you money, and in turbulent markets, it will cost you a good deal of money. The global financial crisis was in a sense the revenge of the Efficient Markets Hypothesis. Those who ignored the “no free lunch” principle and chased illusory excess returns were ruined (or would have been ruined but for their successfully persuading the state to bail them out). The biggest moral hazard of the egregious bail outs of 2008 is that the financial sector has still not internalized the “no free lunch” principle of the Efficient Markets Hypothesis. That is a tragedy for which surely the taxpayer will one day have to pay once again.

In fact, the term hedge seems to have a very different meaning in the financial sector than in the corporate sector (or perhaps, I should say the old fashioned non-financialized part of the corporate sector). If you are an airline that hedges oil price risk, chances are that you are more prudent (more risk averse) than the airline that does not hedge its risk. This is because all airlines face somewhat similar oil price risks and the one that hedges is probably less risky. At least that would be the case if the airline does not use oil price hedging to justify an excessively high level of debt in its capital structure (that was why, I began by confining my remarks to the old fashioned non-financialized corporate sector).

In the financial sector (and in highly financialized industrial companies as well), things are very different. The bank that puts on a hedge does not necessarily keep its portfolio unchanged. On the contrary, it uses the hedge to take on more risks on the underlying portfolio. The total hedged portfolio is not necessarily less risky than the original unhedged portfolio. Chances are that the hedged portfolio is riskier – much riskier.

At a theoretical level, this was established more than three decades ago in a very interesting and highly readable paper by Hayne E. Leland (“Who Should Buy Portfolio Insurance?”, The Journal of Finance, 1980, 35(2), pp. 581-594.) Leland started with a very simple observation: since derivatives are zero sum games, for every buyer of portfolio insurance, there must be a seller. He then asked the obvious question – which investors would buy insurance and who would sell them.

If one were naive, one might be tempted to answer that the buyers of insurance must be either bearish on stocks or highly risk averse while the sellers must be bullish on stocks or highly risk tolerant. Leland’s answer was totally different. He showed that the bears should be selling insurance and the bulls should be buying them. The reason is that the bulls would load themselves up so heavily on stocks (possibly borrowing to buy stocks) that they need downside protection to maintain the position at all. On the other hand, if you are so bearish on stocks that you have put all your money in bonds, clearly you are not going to be buying portfolio insurance!

The situation regarding risk aversion is more complex. Everything depends on how risk tolerance increases with wealth and it will take too long to describe that argument here. The interested reader should read Leland’s original paper.

Anyway, the key point is that the hedge permits the underlying portfolio to become riskier and more toxic. It is like the old adage that the brakes make the car go faster. So when the banks argue that they need complex derivative products to hedge their risks, what they really mean is that they need these derivatives to create very risky asset portfolios while managing the downside risk up to the point where it can be palmed off to the taxpayer.

To quote another adage (this time from the world of financial trading itself), hedging in the financial world is nothing but speculation on the “basis”; it has little to do with risk reduction.