‘Everything Is a Hedge’

The claim is being made that JP Morgan’s $2 billion trading loss was in a trade that was a “a hedge.” It doesn’t take much review to easily disprove that position.

We first learned of this particular trade when they began to distort credit indices. Any trade so huge that it impacts its markets – that becomes the market – cannot be credibly thought of as a hedge. Simply stated, once you are the market, you are no longer a hedge. Sheer size of this trade makes it far more accurate to describe this as speculation than hedge.

Of course, the loss was the tell. A true hedge would have been offset by the underlying position that was being hedged — so any loss should have been insignificant. Even a minor correlation error should not lead to a $2 billion dollar hit.

Which begs the question, what is a hedge? It is a position taken in order to curb the risk of a specific (or arguably general) trade. This is not a new concept: The word “Hedge” has been used as a verb in English since at least the 16th century (See Shakespeare’s Merry Wives of Windsor).

Looking at the question a little differently, what isn’t a hedge? There is always the other side of the trade, and that side (if not position) is what  you can theoretically claim to be hedging. Hence, for a huge bank with trillions on its book, there is the rationale that any trade, any position, any financial transaction, is potentially a hedge against some other position the bank is holding. Recall that Goldman Sachs, who has been rather silent on the JPM trade, used the same logic when arguing they were not betting against clients; rather they were “hedging other bank positions.”

Poppycock. Both the JPM and GS arguments fail, for a simple reason: If we are going to define this trade as a hedge, then there is no other conclusion to reach except that everything at a huge bank is a hedge.

And once you define everything as a hedge, well then, nothing is a hedge.

This post originally appeared at The Big Picture and is posted with permission.

One Response to "‘Everything Is a Hedge’"

  1. mmhl   May 19, 2012 at 1:35 am

    I personally think the concept of attempting to hedge the bank's exposure within a central unit that has better perspective of the overal net positions of the bank is fair. To attempt to regulate along the lines of hedge vs. directional trades is really poorly thought through and ultimately unenforceable.

    In an incomplete market, there is, more often than not, no perfect hedge for positions, especially that of complex securities with exotic payoffs. In partial hedging, one would attempt minimize the expected loss based on some loss functional. These are all model-based, and as we saw with the credit crisis, models are highly susceptible to being misused without regard for the underlying assumptions. Take for example the use of the Gaussian copula in pricing CDOs etc. There is much more literature about this since the crisis.

    I do take your point about how the bank should surely question if their "hedge" would be effective if the position is large enough to move markets. Personally, I think it is crucial that we consider the dual role of prices. On the one hand, they are reflections of the underlying fundamentals of an asset, but on the other hand, they are also an imperative for action. As such, when an agent in the market is able to move markets, that leads to distorted behavior and amplification mechanisms. This should lead the "hedger" to question the efficacy of his "hedge".