Hedge Accounting

Ooh, juicy topic.

This one's all about how to account for derivatives. Puts, calls, options of other flavors, and probably most importantly in practice...futures.

So you're ShmoopWest airlines and you need Jet A fuel to live. That is, without it, your business dies. You have to carry "Middle East Bomb Life Insurance" always, meaning that you always have to hedge your costs of fuel so that in the unlikely event of a water landing, er...a spike in oil prices...you don't suddenly go from paying $40 bucks a barrel for oil to $100.

If you did, then it's likely that virtually all of your competition was at least partly hedged, so their real cost is now more like $70 a barrel. And with the knowledge you didn't hedge, they could drop prices on your routes and drive or fly you out of business fast.

So you own an endless series of futures on oil. And the market is wild. A few quarters go buy and, for whatever reason, you've made a fortune on your hedges.

You're ShmoopWest, not Goldman Sachs. So you don't make a living trading derivatives. How do you account for that quarter's gains? You paid $30 million for hedges expiring the next 2-3 quarters, but rumors of bombs sent oil spiking, and now those hedges are worth $182 million. Do you mark them to market?

It happens to be the end of the year and, if you do, you'll show a gain of $152 million. Misleading? Maybe. Shareholders don't expect you to make a business trading hedges; they want you to fly your damn planes on time. And how do you really account for hedges anyway, particularly when they get all exotic? Like...a call on a call with a swaption embedded? You need a PhD half the time just to understand what these things even mean, much less how to price them.

So maybe you just leave your hedges at book value, i.e. whatever you paid for them, and then as they expire, you do the cash calculations as to whether they made or lost money for you. This is an exceptionally difficult problem in hedge funds...the things that take 20% of profits each quarter as their compensation.

Like...fancy math might show a huge gain one quarter in a blip on a call on a call; the hedge fund would clip a huge gain from that trade that quarter, only to see it all unwind and be worthless 90 days later. Vastly complex area.

Caveat Emptor: if you don't trust the hedge fund managers with your wallet, don't invest. The accounting is just gnarly (technical term).