To hedge or not to hedge, and how to hedge

Some businesses face volatile inputs that they cannot control. Airlines have to deal with a volatile oil price, which determines much of their costs. Exporters need to consider exchange rate movements and their impact on competitiveness in international markets. Gold miners need to consider whether to hedge fluctuations in the gold price to make revenues more predictable. If a company decides to hedge these risks, what is the best way to do it?

First, deciding whether to hedge volatile cost factors like the oil price or exchange rates is a matter of business strategy. Hedging these costs has the advantage that it smoothes costs and makes profits more predictable, at least as long as costs can be hedged, typically up to one year. Analysts and investors like this kind of predictability, and thus, many companies choose to at least partially hedge these costs.

The problem with hedging is that once the hedge runs out, the company faces potentially significant cost changes if oil prices or exchange rates have moved significantly. This, plus the costs and potential complications of hedging (the oil price is only a proxy for the fuel costs of airlines, for example), leads some companies to decide not to hedge these input factors at all, even if that comes with higher volatility in profits in the short run.

In my experience, most exporters will at least partially hedge their exchange rate exposure, and energy-intensive companies will at least partially hedge their input costs from energy commodities.

This is where consultants and experts run complex models to assess how much of the input factor to hedge to achieve the optimal reduction in downside risks. It reminds me of the investment consultants who use sophisticated models to assess the optimal strategic asset allocation and help pension funds determine how much money to invest in which asset class.

Alas, in the case of investment consultants and strategic asset allocation, a naïve asset allocation where the same amount of money is put into each asset class typically outperforms more complex models.

And something similar happens in hedging strategies. Min Cao and Thomas Conlon from University College Dublin examined a range of commonly used techniques to hedge downside risks. They looked at simple, ordinary least squares regression techniques, Monte Carlo simulations based on historical data, and the more advanced techniques of Copulas and others. They also compared the effectiveness of these more or less sophisticated techniques with the simple decision always to hedge 100% of the company's exposure.

It's a beautiful paper to read, at least for me as a former quant, because it is full of tables with all kinds of results for all sorts of downside risk measures. It’s the kind of answer you get when you ask a question to a quant. In this case, the question was: How much should I hedge, and what is the reduction in downside risk? To which the answer is: Here are twenty pages of tables with the reduction in Value at Risk and Conditional Value at Risk for different tail risk levels and the reduction in upside potential for the same metrics. Oh, and while we were at it, we also did a couple of calculations on semivariance reduction…

To make life easier for non-quants, the downside value at risk is reduced by over one year. The exact numbers aren’t that important. All you need to realise is that the naïve hedging strategy of simply hedging all the exposure to the oil price, the Sterling/Dollar exchange rate or the gold price performed better or at least as well as the more complicated models. So, don’t bother making things more complex than they need to be. If you are worried about hedging risks from exchange rates, oil prices, etc., hedge them in their entirety.

VaR reduction from different hedging strategies

Source: Cao and Conlon (2025)