Hedging and Betting

It goes against my predispositions, but watching congress discuss derivatives in terms of “betting” — which is a socially stigmatized activity — makes me want to clarify some uses of these bets that aren’t pure speculation. Consider Norway. Norway is a nice little country that gets to be extra-special nice since it has all this oil wealth. At the current price of oil, Norway’s in great shape. If oil gets more expensive, Norway will be in even better shape. If oil gets cheaper, Norway will be in worse shape. Norway is, in other words, “long” oil in a big way. But if you were a prudent investor, rather than a small country, you almost certainly wouldn’t deliberately choose to invest as heavily in oil as Norway has. Norway is so deep into oil by an accident of geography, not a deliberate choice. So it might well be in Norway’s interest to invest heavily in instruments that pay off if the price of oil declines.

That’s financial prudent because it means that the course of Norwegian finances are less dependent on the future price of oil. It’s also politically prudent because it means that Norway, as a country, would no longer be financially committed to a pro-oil position in international relations. Norway could actually hedge itself into a posture of blissful near-indifference to the fluctuations of the oil market.

Now it’s possible that if Norwegian politicians did that (or maybe they already do) that someone would go running around the Norwegian countryside accusing Norway’s financial managers of “betting against the Norwegian dream.” But that implies a level of intentionality that doesn’t need to exist there. When you bet on the Redskins to cover the spread, you’re doing that because you actually think that outcome will happen and you’re hoping to be proven right. If Norway “bets” on cheap oil, they’re trust to reduce their exposure to downside risk — the people placing the bet may have no opinion whatsoever on the likelihood or desirability of that outcome.

On the flipside, an airline might want to make the reverse bet. Anyone who’s already made large fixed investments in creating an airline is, in effect, “short” oil just as any country that happens to be located on top of oil is de facto “long” oil. So if the airline wants to mitigate its risk, it will want to “bet” that the price of oil will go up. Which is to say that it wants to ensure that if profitability declines due to higher oil prices, that you’ll be compensated via derivatives.


Now for regulatory purposes, you can draw whatever kind of distinction you want between these kind of activities and more properly “speculative” ones. But the distinction isn’t going to be very conceptually rigorous. You could be assembling a portfolio of bonds (speculating, that is) and decide you want to use derivatives to even out the risks involved in your different positions — hedge the riskier positions to make them less risky, in other words. Now you’re hedging. But the reason you’re hedging is that you’re speculating. But the real reason you’re hedging is that just like airlines and Norway you face an uncertain world and are trying to manipulate your exposure to it in different ways. On the one hand, I think it’s unproductive to try to stigmatize some sub-set of this activity as “speculative.” On the other hand, I think it’s equally unproductive to try to carve-out some valorized exemption to the general regulatory framework.