The Swiss National Bank’s (“SNB’s”) decision to abandon the currency ceiling of the Franc relative to the Euro has drawn attention to risk management and hedging. The losers from the SNB’s actions, including retail leveraged trading platforms, investment banks and hedge funds (perhaps ‘directional funds’ is a more appropriate description in this case), became clear relatively quickly. The winners from the SNB’s decision have been harder to find.
A number of Swiss pension funds have been mentioned as beneficiaries of the move. They have indeed generated large gains from their positions going short foreign currency and long the Franc. However, these positions were not (in the main) standalone investment decisions but rather hedges against foreign currency exposure arising from underlying investments. The value of these underlying investments fell by a corresponding amount, in Franc terms, when the ceiling was abandoned. Overall, these pension funds were not materially impacted by the SNB’s decision as the funds had managed their foreign currency risk given their liabilities are Franc-denominated.
Hedging of interest rate exposure, be it nominal and/or real, has become a more common feature of the pension fund and insurance landscape over the last two decades. Those that have hedged their interest rate exposure have generated strong absolute returns from this activity, during a period of falling interest rates. These returns have offset corresponding increases in the present value of the associated liabilities, so the net asset/liability position (related to the hedge) has remained unchanged. A decision, whether intentional or unconscious, not to hedge interest rate exposure embedded in liabilities may be characterised as an investment decision more so than the decision to hedge. In the case of not hedging, the decision-maker has chosen to retain exposure to a risk.
The concept of the ‘risk/return trade-off’ considers the return generated for taking a particular risk. Seeking to protect against a loss, through hedging a risk exposure, is quite different to actively seeking a gain. Many large trade pay-offs generated this millennium have been the result of prudent risk management decisions. These pay-offs, while delivering positive cash flow, have not been outright gains but have offset corresponding losses elsewhere on the balance sheet of the entity putting on the trade. Had the hedges not been in place, the entity would have been proportionately worse off for leaving the risk unmanaged. Effective risk management can have a material impact much like that of profitable risk-taking, so why is the former so easily overlooked and the latter so widely lauded?