Irrational moi
4 August 2010
Sean Russo
BEHAVIORAL finance (or as it is sometimes called, behavioural economics) is a relatively new field. It is the study of the psychology behind the behaviour of financial market participants. It seems to be largely ignored by classical economists because the very essence of their belief/faith is that markets reach rational outcomes; whereas, the behavioural economist observes the regular irrationality of markets and market participants and seeks to understand the drivers. Keynes clearly had sympathy with their view when he quipped, “markets can remain irrational for longer than you can remain solvent”.
One of the most cited papers on this topic was written by two psychologists Kahneman and Tversky in 1979 on something they called Prospect Theory. They presented empirical evidence that investors/managers tend to attribute value to gains and losses, not the underlying asset, and they feel losses (or seek aversion) more deeply than they enjoy (seek) a corresponding gain. They also discovered that when individual investors weight decisions they generally weight them lower than the actual probabilities. In short investors/traders/business owners have an irrational tendency to be less willing to gamble with profits than with losses.
I think that most of us would intuitively agree this is right – about everybody else anyway!
With Diggers & Dealers on this week I thought I might run an experiment of my own on this subject. I have set up a stand with the following proposition for the lab-rats. I will commit to give them a certain $A100 at next year’s Diggers regardless of the gold price or we can agree that I will give them $100 if gold is up more than $A100/oz and they will give me $100 if gold is lower by more than $100/oz: a simple decision for them it would seem.
(Before making your determination on the likely outcome remember some of these people, in a similar experiment down the road, will toss $2 for the possibility of a flash from a skimpy but accept is as perfectly logical that she keeps the money either way! But I digress unfairly as it is universally accepted that rationality flies out the window as the male brain migrates south!)
Classical economists would tell you I will pay a great deal of money out this year. Not so, it appears, when you wrap that offer up into an option hedging structure and call it a ‘zero cost’ something, given several of the recent hedges that companies have done. A banker offering ‘zero cost’ anything should probably be cause for suspicion, but let me deal with the nomenclature first and then I’ll get back to the catch.
“Zero cost” option structures such as those where you sell 1000 ounces of calls at a gold price $A100/oz above the current gold price to buy 1000oz of puts at a price $A100/oz below the current gold price are not without cost, they are without upfront cash flow. That is, they are self financing by virtue of selling a call to buy a put. At Noah’s Rule we train our people and our clients to call them a “zero cash flow” structure; the “cost” of the structure will only be known at the expiry date or sometime prior should you seek to unwind it.
Having established that a zero cost option structure is not zero cost, what are the costs of selling calls to buy puts? The simplest way to consider this issue is to think about the fact that option pricing theory says that the sale of a call option with a strike at the prevailing forward price on any future date will raise sufficient funds to buy a put option of the same strike price on the same date. That is, if the 12-month forward price is $A1350/oz, then selling $A1350/oz call options one year hence would fund the purchase of an equivalent number of $A1350/oz put options to the same date; no cash required.
This equal value of the right to buy or the right to sell in option pricing theory says the range of possible future outcome is evenly distributed – gold higher or lower is a coin toss because all information is known and all markets are rational. This simple strategy commits the seller of the call to one ounce at a maximum price to secure the right but not the obligation to sell one ounce at a minimum price; if it sounds familiar it should be because it’s identical to a forward sale at $A1350/oz. One ounce committed at $A1350/oz, one ounce covered at $A1350/oz, no initial outlay; which is why this strategy is known as a synthetic forward.
If you follow the concept it won’t surprise you that as a rough approximation if you reduce the strike price of the put to $A1250/oz (forward price less $A100/oz) then you can raise the zero cash flow call strike to $A1450/oz (forward price plus $A100/oz). One ounce committed at $A1450/oz, one ounce covered at $A1250/oz, no initial outlay. If a producer enters into this strategy they essentially know that for the ounce they have hedged they will be able to put the ounce to the option seller at $A1250/oz if the price is lower than that, to deliver an ounce of gold and receive $A1450 or meet the equivalent loss and no more than $A1449/oz there is no need to trade or deliver.
On the surface the ultimate cost of this strategy appears to many to be the opportunity cost to the producer if they are called at $A1450/oz because the price at expiry is higher, such that the strategy has denied them of that gain – that is, at any price below $A1450/oz the strategy was achieved for ‘free’. It is here that I would like to point out what I believe is the flaw in the logic/approach of the many people who seem to favour this approach to hedging over using simple forward sales and how it seems to demonstrate quiet well the research of Kahneman and Tversky.
A gold producer who chooses a zero cash flow $A1250/$A1450 option strategy over the equally available $A1350/1350 strategy, or equivalent forward sale, does essentially have a cost from day one. They give up a certain $A100/oz of guaranteed revenue (the difference between $A1350 and $A1250) to chase a possible $A100/oz (and the market needs to rise by more than $A100/oz for that to be achieved due to contango). If you are bullish you might suggest you are being perfectly rational in being willing to trade-off certain revenue for additional potential profit, but on a ratio of less than 1:1 I would argue it isn’t rational.
Based on a number of recent hedges transacted in this manner and a number of discussions I have had with people who insist it’s better than doing a simple forward I believe it reflects in part a misunderstanding of the true nature of the alternatives and possibly more so (and it was a big penny drop for me) it reflects the fact that the boards of gold miners see gold mining and gold hedging as two distinct operations. All too often when they make a decision to hedge they do not consider the benefit to the underlying asset – the gold mine – but instead as our psychologists postulated – they only look at the gain or loss on the hedge. They either have divine insight that gold prices will be significantly higher in the future to justify the risk reward or they fear making any hedging loss so greatly that they ignore the certain benefit to the mine and its owners of that certain $A100/oz to push up the price to where an external observer might note a loss made on a decision they made.
Am I being unkind?
If the gold price at expiry is $A1351/oz the company has essentially paid $A100/oz to make $A101/oz. That’s not zero cost nor is it a great return.
If the gold price is at $A1100/oz they have given up $A250/oz to make $A150/oz. That is, they have lost $A100/oz on the alternative approach. If the gold price is at $A1600 they have given up a certain $A100/oz made an uncertain $A100/oz and a ‘loss’ of $A150/oz for an overall outcome of being $A100/oz better off than the forward seller but in terms of delivery risk, which should be a major consideration in all hedging decisions they never had less risk than the forward seller.
Further, a producer (being slightly rational and thinking about the underlying gold mine at the same time) wanting to secure certain future revenue to meet operating costs and/or debt service needs to hedge more ounces at $A1250 and therefore commit more at $A1450 than the producer who locked in the certain $A1350.
So the irony is that the bullish guy, if that’s his justification for going ‘zero-cost’, actually often commits more gold and gives up more possible upside than the forward seller needs to do in order to achieve the same outcome. Not what I would think is the appropriate action of a rational gold bull (or someone wanting to reduce delivery commitments). Our psychologists wouldn’t be surprised because the concentration is on the hedging loss (the risk of the wrong decision to hedge) and not the possible loss at the mine.
Let me be very clear. I do not wish to criticise any company that hedges sensible amounts of production with any sensible strategy and a zero cash flow collar is more sensible than having no certainty if you have no debt and infinitely more sensible if you do have debt.
In the current market it takes courage to do what you think is right for all stakeholders when the crowd (or at least a vocal minority) is so convinced hedgers will burn in hell.
What I simply wish to do is to encourage the mining industry to look not at the gain or loss on the hedge in isolation but look at your business more rationally. First, don’t look only at the gain or loss on the hedge you are contemplating, look instead at the overall revenue of your business and its changed sensitivities over the period of the hedge. Secondly, please give reasonable consideration to the relative impact of both the decision to hedge and the decision not to and try to weight the probabilities of both price movements and impact of those potential price movements fairly. After all, sensible hedging and a higher price is still better than no hedging and a much lower price (whatever probability you currently put on that) and bear in mind that your investors in the latter circumstances are going to be feeling that loss disproportionately and that’s absolutely going to become your problem.