ETF Securities is now providing levered 2X ETFs on four popular European indexes (see Financial Times article, Citywire article). The eight ETFs being offered include both long and short exposure on the FTSE 100, Dow Jones Euro STOXX, CAC 40, and DAX. The four 2X short ETFs will carry annual management charges (AMC) of 60 bps. The 2X leveraged long ETFs will carry charges between 40 and 50 bps. The company is offering the ETFs to allow fund managers the ability to hedge portfolios in place of borrowing stock or using derivatives.

In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

In a recently published research paper in the Journal of Applied Corporate Finance, Tim Adam (from the MIT Sloan School of Management) and Chitru Fernando (from the University of Oklahoma Michael F. Price College of Business) report in their research paper "Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers" that during the 10 year period of 1989-1999, the gold derivatives market was characterized by a positive risk premium that resulted in short forward positions generating positive cash flows. The authors found that the gold mining companies that hedged their production during this time realized an average cash flow gain of $11 million, or $24 per ounce of hedged gold per year, compared on average to an annual net income of only $3.5 million without hedging. Of interest is that as a result of the positive risk premium that resulted from a positive spread between the forward price and the realized future spot price, short derivatives positions did not result in significant losses, even when the price of gold increased. In summary, hedging helped increase profits.

Also of interest in the article was the finding that there was also a significant level of volatility in corporate hedge ratios, implying that some managers were incorporating market timing into their hedging strategies (no surprise, as hedgers will sometimes begin to speculate). The authors found that attempts to time the market by "selective hedging" were futile and unprofitable, even causing the company to consistently lag the markets as they attempted with little success to successfully adjust their hedge ratios in response to expectations regarding market direction.

In summary, hedging helped profits, but the benefits were from hedging, and not from the risk managers ability to predict price moves as they set their hedge ratios. Therefore, one can expect, at least for the gold mining companies, that while earnings and profits may remain volatile, those investors holding longer-term investments should see higher returns from companies that successfully implement and execute a defined hedging program that do not try to engage in market timing. While it is difficult to know when any company that you are investing in begins to move from hedging to market timing, at least knowing that a company is hedging will give you the potential for higher returns as long as you can weather a few up or down moves that may temporarily reduce profit margins.

Just last summer as crude oil moved towards $150 a barrel, some companies were being applauded for having had the foresight to hedge their energy and fuel cost by locking into lower prices for future delivery. Unfortunately, as crude oil fell sharply from its summer highs to below $40 a barrel, some of these same companies were now finding themselves on the other side of the profit/loss equation (see WSJ article). Just recently, Delta Airlines reported a $507 million loss on its fuel hedges in Q4, while UAL reported a $370 million hedging-related loss. Southwest Airlines, known in the past for its smart use of hedging, is finding that its needs to post $300 million in collateral with its various counterparties as the price of crude oil and fuels continue to decrease. Not surprising, or maybe surprising to some, it how investors are punishing the stocks of those companies that were considered to be "prudent" in their use of hedging. What is often forgotten by both investors and management is that hedging is not speculation, or at least should not be treated as such when done correctly. A properly managed hedge should theoretically provide a predictable cost, but changes in the price structure of an industry could cause earnings to be volatile, not to mention the company stock price.

For instance, if an airline company has hedged its fuel cost based on crude oil being around $70 a barrel, the company should see some benefit compared to its un-hedged competitors as crude moves above $100 a barrel. Yet if companies in the industry have pricing power, they can pass some or all of this cost on to their consumers. Therefore, higher costs are followed by higher product prices (obviously, never exactly one-to-one, even with pricing power). For the un-hedged company, their profit margin will theoretically be the same, while the hedged company will experience increased profits due to their lower cost structure compared to their competitors. On the other hand, as crude oil prices fall into the range of $30 per barrel, the un-hedged companies could once again adjust prices, but now to reflect their lower cost (and attempt to take business from those paying higher costs who may not be able to adjust prices as quickly). Those companies that are hedged and are forced to pay the higher $70 per barrel price will experience a lower profit margin, lower earnings, and potentially a lower stock price.

So while hedging can help a company "lock-in" to a specific cost structure, if others within the same industry are not hedged, and those companies have pricing power, the hedged company can expect to see higher swings in profit margins and earnings, and subsequently a more volatile stock price. Not only does this surprise investors who were expecting a less volatile stock given that the company was hedged and should experience consistent costs, but it also generates inquiries from management as to why the risk management department suddenly turned into speculators, and more importantly why they made such a bad bet. In reality, the hedging allowed the company to control what it could (the cost), but still left it at the mercy of what it had less control over - industry pricing and investor reaction. Something to keep in mind as you invest in companies and industries that actively engage in hedging, especially in commodity markets that are volatile.

Hedge fund executives are telling CNBC that Wall Street is beginning to market a new hedging product that would allow them to short stocks on the banned short sale list (see CNBC article). No doubt that this will be a new derivative-based product given that puts and other derivatives are still allowed to be sold, and that market markers are still allowed to short securities in order to hedge their own writing of derivatives. Many opponents of the new products feel they are nothing more than a loophole to the SEC order. Of course, those introducing the products stress that they will only be used for hedging purposes. Yet, it is still not clear to me how you verify this, or whether this will be just another "wink-wink" arrangement where it is assumed that everything is for hedging purposes. If the shorting product is abused and impossible to verify for hedging, then the ban on shorting financial stocks will prove to be useless, unnecessary, and itself a loophole for creating stable markets and handcuffing those who are thought to be causing the problem. In fact, does anyone else find it strange that the very firms that are protected by the short selling ban are developing products to find a way around the restrictions? Are hedge funds biting the hand that feeds them, and are financial companies just facilitating their own destruction? It all seems a little odd to me. Then again, I am still trying to understand the logic of mark-to-market accounting for illiquid assets, or why rating agencies can be so wrong and so late, yet still have the power to start the financial dominoes falling. Not a lot makes much sense right now.

Commodity index investors (ie, speculators) sold $39 billion worth of crude oil futures between the July market peaks and September 2nd, a time that saw a rapid sell-off in crude oil prices (see Independend.ie article). The analysis was once again done my Michael Masters, president of Masters Capital Management, who recently blamed speculators for driving up prices. The drop also comes at time when the IEA is forecasting lower demand, and pension and hedge funds are unwinding commodity positions, each of which have put pressure on prices. In the end, such debate may be academic as to whether we call those selling speculators (be it hedge funds, pension funds, index funds, or individual traders). Given the exposure we all have to pensions and index funds (even us retail money mortals), we all might be classified as speculators, notwithstanding the evil mustache-twisting monopoly banker image. Of course, all this talk says nothing as for whether speculators are even inherently bad for the markets in whole (see US News & World Report blog). After all, who is going to take the other side of the position when a company is looking to hedge its risk? If the market is rising or falling, will there always be the perfect number of textbook farmers and bakers on the other side of the wheat contract? Probably not. How many companies will show higher profits, or at least less loss, due to placing proper hedges? Raising margins to decrease leverage and unhealthy exposure is one thing, but making it more difficult for the market to even function is another. If we eliminate all trades and traders that don't actually plan to buy or sell the commodity, liquidity will decrease. If this does happen, individuals may find themselves living in a much riskier world, even if the price of crude seems a little less volatile day-to-day.

Recently there was an interesting article at Spiegel Online regarding the faces of commodity speculation, as told by a farmer, baker, banker, and hedge fund manager. The use of the futures market by both the farmer and baker (hedging against falling and rising prices, respectively) are well known, as is the interest by both investment bankers and hedge funds, but the perspectives offered by the participants are interesting nonetheless.

While the article highlights only four individuals/institutions, and is somewhat anecdotal, it does offer a few observations. For instance, the following quote from the farmer is telling: "Farmers who don't have supply contracts at the moment are now calling the shots." This particular farmer, who had not yet signed a contract, is planning to sell only half of his crop to the cooperative at the end of July at the current price. He then plans to store another 50% until at least October in silos in the hope that prices will rise further. He admits that farming is becoming more speculative and that he is willing to take the risk. Quiet a turn of events and roles.

The baker on the other hand is worried about speculation and the associated risk, and is still worried that his raw material costs will be too high. As prices have increased, he is being forced to pass cost increases on to his customers, and is worried that the markets he must now operate in are too unpredictable. Since the EU has abolished intervention prices - which had helped to regulate the market he operates in, prices are now set at the CME, which he worries is being driven by speculators.

The investment banker is, not unexpectedly, trying to take advantage of the market by offering new products, such as certificates whose value rises or falls along with the price of food commodity contracts on the CME. Of interest from the investment banker is the quote of how they want to "provide each private investor with a toolkit he can use as if he were a hedge fund manager worth millions." This brings back memories of people quitting their day jobs in the late 1990s to trade stocks online at home, only to see the market correct violently. As has been pointed out by others numerous times before, when the average investor begins talking about securities and markets that he or she never talked about before (day trading tech stocks before, commodities and futures this time around), it is usually the sign that a top in the market is near.

Finally, a hedge fund manager was interviewed and pointed out that he no longer trades crude oil futures (ironically, since they are too speculative), but continues to watch them closely, since at the moment "... oil futures are the measuring stick for everything." Whether trading in oil futures or not, the fund manager needs to know how high crude oil might go given that its price has such a strong impact on the stocks he trades. Many other traders have also expressed how crude oil is affecting nearly every other asset, and how crude oil itself is becoming the new global currency. Right now that currency is in an uptrend, but volatile, and worrying market participants of a correction.

A recent WSJ article highlights a commonly overlooked effect or consequence of commodity trading - that of bad hedging or speculation bets causing buying pressure, driving prices higher. As for speculators, we often assume that they are just following the short-term trend, which is currently up, adding further momentum buying pressure. Sometimes the buying pressure comes from speculators and hedgers that are simply exiting out of a bad past position, either due to margin calls, or simply because they can no longer take the pain.

Many producers entered into contracts to sell crude oil in the future, locking into higher prices for future delivery. While the future prices were higher than the spot price at the time the contract was written, some of the contact prices are now as little as half the current spot price, even for contracts with a delivery of less than one year. As a result, companies and traders are being forced to close these deals by buying back existing contracts that were wrote just months ago.

Longer-term trading has increased over they years, with Nymex oil futures contracts tripling over the last four years, with much of the growth coming from futures contracts that expire more than one year out. This form of long-term hedging and speculation was relatively rare in the past and is certainly contributing to some of the current increase in trading activity and price movement as these trades, which were probably not expected to be as speculative, are now needing to be unwound.

A recent Bloomberg article also discusses the impact of speculators selling out their contracts, but focuses more on short-term speculators that have recently closed out short positions after making bets that the price of crude oil would decrease after the recent run-up. The closing of these contracts has put further buying pressure on the commodity. As evidence, open interest has been falling for months. The CFTC list how "non-reportable" small-size speculators have been closing out their short positions, which were 47% higher than long positions. Any time you have a rising and shrinking market (open interest is decreasing, while prices are rising), it is usually a good indication that speculators are closing out positions and leaving the market.

Reuters and other outlets are reporting that a House of Representatives committee has started considering opening up a formal investigation into energy market speculation. Hedge funds and investment banks are expected to take the most blame during the investigations. Word is that some representatives are discussing the possibility of changing the margin requirements for crude oil and other energy commodities as a way to curb speculation. As with most things Congress gets involved in, the best we can often hope for is that they consider the unintended consequences of any new laws and/or regulation. Even something as simple as raising margin requirements would have the effect of reducing the amount of leverage available to speculators, causing some to move to greener pastures, but it could also have the unintended consequence of making it more costly for companies that truly need to hedge their energy cost exposure. Not only would higher margins potentially tie up more capital for these companies, keeping it from being deployed for more useful purposes, but the increase could also have a negative effect on liquidity - after all, someone needs to take the other side of the trade. It is true that speculators can overtake and artificially drive a market, but they are also necessary to help provide a market for those looking to take a hedging position. As price fluctuations increase, margin requirements should reflect sustained increases in volatility. Nonetheless, simply increasing margin requirements in a hope to eliminate speculation may do nothing more than drive out those who need the market the most.

The New Zealand Rugby Union "dodged a financial bullet in 2007" by hedging against movements between the New Zealand dollar and the U.S. dollar. The hedge was put in place as the New Zealand dollar briefly dropped to 68 cents against the U.S. greenback. The Union hedged more than $24 million U.S, and ended up saving $6 million as the New Zealand dollar rose to 77 cents against the U.S. dollar. No word exactly what they were hedging against (possibly salaries for U.S. players?). Maybe speculating, and not hedging, might be a better description of their position, but who really know.

The globeandmail.com is reporting how EnCana's hedging strategy "backfired" as the company recently hedged 40% of its expected 2008 natural gas production at around $8, while prices for natural gas are currently over $10. The impact of the hedging showed up in Encana's first quarter results as profit plunged to $93 million from $497 million a year earlier, with the decrease in the first quarter resulting from unrealized hedging losses. While Encana's 2008 hedges have not expired, mark-to-market accounting generated the balance sheet losses as natural gas prices moved above the original $8 contract price. Also mention is how the Encana executives are "looking on the bright side" as the higher prices have helped the 60% of their production that is not hedged.

As usual, it is interesting how hedging is considered to have backfired when it turns out that you would have been better off being without a hedged position. Of course, if it had turned out that $8 was the top, and Encana was selling the majority of its 2008 production for $6, then the same authors, and many shareholders, would be wondering why the company did not lock into prices when they were so high. Rather than seeing a "backfired" strategy, Encana's approach to managing their business appears sound and stable, and less risky and foolish than one might expect.

Tickers: ECA

The airlines, some of which have been hedging, some of which have not, are finding themselves in a difficult position - do they hedge the cost of their fuel with crude oil around $120 a barrel, and jet fuel near $3.50 a gallon? These companies must decide whether it is time to lock into prices, or whether they should simply be at the mercy of the future spot price, hoping that when they need fuel 3 to 6 months out, the market will be a little more "rational".

With high prices for fuel, it helps to drive home the point that hedging is not always the most profitable, or short-term earnings friendly move, but may be a smart long-term play. When prices are rising, then yes, you get the benefit of buying fuel on the cheap, and possibly the added benefit of raising product prices along with your competitors to compensate for the higher overall fuel cost (which may not impact you as much since you were hedged). But the story is different on the down side. As spot prices fall, you are locked into higher priced futures contracts for your raw material and energy needs, while your "risky" competitors who decided not to hedge, or simply could not hedge since they were not credit worthy and did not have the proper margin, are taking advantage of lower spot prices. To add insult to injury, you no longer have pricing power, and may even see price cuts as your competitors put the squeeze on you. If options are employed instead of futures, such that you have the right but not the obligation to pay the higher strike prices as spot prices drop (compared to how you would be obligated with a futures contract), you still do not get away unscathed. The options you buy will not come cheap, and are likely to be quite expensive during times when prices are volatile - just when you are probably most interested in hedging.

Of course, is this really what hedging is about - trying to time the market? Ideally, no. Let us look at the airlines again. In an attempt to have some forward looking predictability, they book revenue by selling tickets 3-6 months out. Shouldn't they be hedging their fuel costs now, for payment 3-6 months forward, to insure that given the prices they are currently selling tickets that they can make a profit in 3-6 months based on revenues (ticket sales) and cost (fuel) they will realize at that time? I would think so. Why do many fail to do exactly this? Well, there are probably a number of reasons, but a short-term perspective which is more interested in making earnings next quarter is probably one of the biggest culprits, not to mention those pesky credit issues. It is the classic problem for risk managers. They love you when the hedge "works", but hate you when it does "not work". If done properly, the hedge works in both situations - high and low costs - but this is not what the CFO and investors see. They only see how the company is paying $3.50 a gallon for fuel when the spot price is $3.00 a gallon. Reminding them that the company only paid $3.50 a gallon when prices were $4.00 a gallon a month ago doesn't compute, nor does the fact that you are able to help the company price its tickets properly in order to generate stable returns, since you know in advance what your cost of fuel is going to be. Ah, don't bother me with those details. Again they ask: "Why is our cost of fuel $3.50 now when spot prices are $3.00." Sigh....

Yet all of this discussion may miss the bigger issue. Anytime a company, or industry for that matter, can only show profits when it gets the hedge "right", or in other words, was fortunate or lucky enough this quarter and showed a profit since their hedge allowed them to cut costs or undercut their competitors, then it might be time to look for other sectors to invest in. Next quarter they may not be as fortunate. Companies that have the same problems with $10 per barrel oil, as with $100 per barrel oil, are simply at the mercy of the markets. These companies may make for an interesting trade at times, but in the end, you might as well take your money to the casino and bet on red or black. At least then you could save transaction costs and the bid-ask spread (well, sort of), while at the same time not worrying about strikes, delays, or passengers stranded on the tarmac.