What’s the biggest bonehead hedging mistake you’ve ever made?

What’s the biggest bonehead hedging mistake you’ve ever made?

I’ll bet it was nowhere near as big as Jamie Dimon’s: the boss of JP Morgan Chase is having to do a bunch of ‘splaining about how a complex synthetic derivative position one of his traders constructed will probably cost the company $2 billion.

Don’t feel too sorry for Dimon. J.P. Morgan Chase will still probably make $4 billion in profit this quarter alone – after the “hedging” loss – so he and they are doing OK. You don’t need to send flowers or a note of support.

But the interesting aspect of this particular situation is the way it highlights the dangerous grey area between hedging and speculation in the derivatives world. And that’s something every farmer can relate to. How far can you push your hedges before the risk you’re laying off is exceeded by the risk you’re taking on? Even the super-smartypants community, of whom Dimon is one of the luminaries, can get stuck in a position in which a supposedly super-safe and balanced position leaves them super-exposed. When aggression, or greed if you prefer, takes over you’re willing to take on more risk to open yourself to more upside, then the potential for big losses grows greatly. That’s what Dimon and J.P. Morgan Chase apparently did a few months ago: decided to take a more “risk-on” attitude to the markets and, well, take on more risk.

In farm hedging you see this with forward sales when the crop completely fails, or when the farmer locks in delivery commitments for too high a percentage of his expected production, falls short on production and the market goes against him. It’s no fun having to buy-in replacement crop and losing a bunch of money when you thought you were being wise and prudent and were insuring yourself against loss. Thank god for act-of-god clauses – if they’re available in that crop. But it takes a lot of discipline to hedge enough but not too much and to stay on top of the position as the crop grows.

Then there’s counterparty risk. That’s what happened to Wall Street in 2008 when everyone thought they had insured all their positions – but discovered that they’d all been insuring each other in a neverending daisy chain that fell apart as soon as one little daisy disintegrated. It’s no fun when your house burns down and you discover that your insurance company went bankrupt last week. Farmers are all aware of how scary it can be to deal with dodgy grain and livestock buyers who fail – or leave town – after they have delivered a bunch of crop or a lot of livestock.

Special crops marketers had to deal with this over the past year as the “Arab Spring” revolts and revolutions disrupted some of the best markets for prairie pulses. Quite a few shipments got stuck on Middle Eastern docks as buyers there ran away from accepting delivery out of fear of the uncertain, lost their credit facilities as local banking systems went into paralysis, or found their companies simply couldn’t operate in a lawless environment.

Hedging and speculation are assumed to live on different streets and only run into each other in the marketplace, when the hedger makes a deal with the speculator which gives the hedger insurance and the speculator a good gamble. But depending how each side structures it, and how far they push things, and even how much they lie to themselves about what they’re really doing (no one ever admits to themselves that they’re being greedy), the hedger can discover that he’s ended up on Speculation Street, and that’s not too comfortable if you had planned to stay in your nice, boring, safe neighborhood. The hedger drove down Risk-Off Avenue, accidentally took the Risk-On on-ramp, and ended up in the wrong part of town.

 

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