When “no trade” is the best trade.
When it comes to derivatives and risk management, there is one crucial piece of advice that is often neglected. After spending over a decade working on the trading floors of Goldman Sachs in Paris and London, alongside some of the best traders in the world, one piece of advice I learned was as follows:
No Trade Is A Trade.
Yes, you heard it right: Actually not trading is a very important decision. In the context of professional traders, people who need to transact to generate a profit and make a living, over-trading is considered as one of the capital sins, alongside doubling down on losing positions instead of cutting losses, or taking profits too early on winning positions.
So, yes, deciding ‘not to trade’ is a very important, and often profitable decision. My last trading boss at Goldman Sachs had a unique trading style. He would spend most of his time studying the markets and deciding not to trade. And a few times a year, he would decide that the balance of risks relative to rewards was so skewed that he felt ‘forced to trade’. And at that point in time, he would commit a hugely disproportionate amount of capital to the trade, and along with it, his hard-earned reputation and credibility.
So why is this relevant to this article’s discussion about Derivatives Markets and Risk Management?
Well, I am inclined to believe that many professionals working in the industry have failed to perfect the art of ‘not trading’.
Having worked with many treasurers, CFOs and risk managers over the last 26 years, many do not realize that by not trading, they may have taken a huge decision, a decision which may make or cost their companies millions of dollars.
Yes, choosing not to trade is a trade, even for the corporate treasurer.
Let us take a few examples:
Example One:
Your company borrows from the bank at a floating rate for five years. You enjoy the low interest rates and wait for the loan to mature to refinance it.
- Well, you have made a big trade
- You have implicitly bet that the five-year swap spread is higher than the average of the floating rates you will pay over the next five years
- Did you know that you can exchange the uncertainty of the next five years of interest payments for the certainty of a fixed coupon?
- Did you know that there is a very simple financial derivative called an interest rate swap, that allows you to mitigate the uncertainty of these floating rates?
- And did you know that the only way to be doing the right thing for your company by not hedging is if you are actually convinced that the Fed will not hike rates as much as the forward market is implying?
- In other terms, by not hedging, you have actually expressed a very strong view, and this view states that you are right and the market is wrong
- On the other hand, actually trading and hedging would have been a much more neutral position as you would have simply agreed with the market and saved your company from the uncertainty of the floating rates
Example Two:
Your company is buying raw materials which will be delivered over the next three years at the prevailing market price
- Derivatives allow you to lock in the price of the raw materials at different dates in the future
- By hedging the price of these purchases, you protect your firm against a sharp rise in the price. You also allow for more accurate budgeting and planning
- By not hedging, you are making the implicit bet that the prices will go down. This only makes sense if you have a natural hedge, such as the ability to increase the price of your contract if raw material prices increase
Again: No Trade is a Big Trade!
What transpires from these examples is an underlying question about the role and responsibilities of the corporate treasurer or risk manager. This is actually a question of corporate governance, and raises some interesting points:
- The role of the treasurer and risk manager should be to reduce risks and uncertainties, and increase the predictability of the firm’s cash flows, both costs and revenues
- Treasurers and risk managers should NOT be speculating in the financial markets with the purpose of making a financial gain
- However, not trading, could be the biggest speculation of them all, as it leaves the firm open to a number of risks that could otherwise have been hedged by using simple financial instruments. These include interest rate risk, foreign exchange risk, commodity price risk, and many others
- Careful attention needs to be given to the existence or absence of natural hedges within the business model: are contracts linked to the prices of raw materials? Can foreign exchange related price increases be passed to customers?
- Once the net risks (after any natural hedges) have been identified and calculated, the most prudent route to take is to actually take action by hedging any outstanding risks
- Further care must be taken when executing in order to ensure transaction costs do not outweigh the benefits of hedging. These include: bid/offer spreads, commissions, regulatory and administrative costs
So, remember ‘no trade is a trade’ – a very crucial decision that is just as important as the decision to trade. It can turn out to be as lucrative or unprofitable as a trade itself. Remember to apply it effectively in your organization to minimize risk wherever possible.