102. The Uses of Hedging30

BY C. O. HARDY

Among the institutions which have developed to aid the business man in avoiding the risks incident to our roundabout, time-consuming methods of production and distribution, one of the most interesting is the system of shifting the risks of price changes, which is made. possible through the use of the futures markets for "hedging" purposes. A hedging transaction may be defined as a coincident purchase and sale in two markets, which are expected to behave in such a way that any loss realized in one may be offset by an equivalent gain in the other.

As applied in the grain- and cotton-futures market, the term "hedging" refers to one of two types of transactions. The first, the hedging sale, arises when a country grain dealer, a terminal buyer, a miller, or an exporter buys grain in the cash market and sells futures contracts of an equivalent amount, as protection against a fall in price during the time that the grain is in his possession. The second, the hedge purchase, arises when a manufacturer has sold his product ahead at a fixed price and buys futures to protect himself against an advance in the price of raw material. The idea is that if the price of cash grain declines a similar decline will probably occur in the futures market, and the loss realized on the one transaction will be offset by a gain realized on the other. It goes without saying that such a protection cannot be obtained without giving up the chances of a profit from a price fluctuation in the opposite direction. Since the hedging transaction involves some costs for commissions, taxes, interest on margins, etc., it is clear that the average result of a long series of such trades should normally be a slight loss, but this loss is regarded as a premium paid for insurance against the risk of such heavy losses in an unfavorable season as would disrupt the business and prevent its continuance through the long run, in which gains and losses from price changes could be expected to balance.

The question may arise, Why would any individual engage in transactions of such a character that the chances of loss and the chances of gain offset one another? The answer is that in changing grain from country points to terminal markets, in milling, in jobbing flour, and in other operations incident to the production and distribution of grain production, the trade or manufacturing profit can be expected under ordinary conditions of competition without reference to any gain or loss from price changes. The hedge enables

30 From Risk and Risk-Bearing, pp. 223-25. Copyright by the University of Chicago, 1923.

the operator to make his price and regulate his business on the basis. of his ordinary trade profit, without the possibilities of speculative loss or gain which arises from the instability of prices. It is impossible to carry on such operations as these without owning grain or its products through a certain period of time, but the hedge enables the operator to isolate the ordinary risks of competition from the special risks, which arise from the instability of prices of the commodities in which he is dealing.

Several advantages result from such a separation. For one thing, the amount of credit which the grain or other operator can secure is much greater. This is true because the protection afforded a bank by the use of warehouse receipts for grain as collateral is much stronger, in case the owner is protected against loss by hedging contracts. The principle is the same as that involved in the custom by which the mortgagors are required to keep property insured for the benefit of mortgagees. In the second place, the use of the hedging contract makes it possible to do business on a much smaller margin of profit. Where hedging contracts are not available, commodities must be handled on a wide-enough margin to compensate for the risk of adverse price changes. When the protection of the hedging contract is available, competition ordinarily brings about a narrowing of the profit margin in accordance with the reduced amount of risk. This is of no financial advantage to the grain dealers as a class, but makes it possible for consumers to receive the benefit of lowered prices, or grain producers to receive the benefit of higher prices, or for both these things to take place, and it also makes the grain dealers' business less speculative.

It is clear that the gains from the practice of hedging are entirely due to the reduction of uncertainty, and not to any reduction in the probability of the unfavorable contingency against which protection is sought. Whenever a man saves himself from loss by hedging through the futures market, someone has to lose to keep him even. The question therefore arises whether the total amount saved by hedgers as a group on transactions, where they would otherwise incur loss, is greater or smaller than the profits they lose in cases where the market moves in their favor. The theory generally accepted among economists is that the speculators who buy and sell hedges to grain dealers, millers, and other tradesmen are specialists in the art of discounting the future, more expert than those with whom they are dealing, and that hedgers as a class, therefore, lose something in the long run to the speculators for their service of reducing trade risk, and from the standpoint of the grain trader should be figured like his commissions, as a premium paid for insurance against risks too great to be borne. No statistics bearing on this question are available, but it does not

seem probable that, as a matter of fact, speculators are more expert than the dealers with whom they trade. Grain dealers, millers, and others who habitually hedge probably stay in business much longer on the average than do speculators, and, therefore, accumulate more experience. The speculative group includes a certain number of professional large-scale operators who do succeed in staying in business year after year, and presumably are making satisfactory profits, but these are the survivors of a large number whose financial strength is exhausted, or whose taste for speculation is satisfied before they attain the dignity of professionals. A few speculators make very large profits, but in all probability the business of furnishing hedging contracts belongs in the list of services which, as a whole, are rendered for society without compensation.

103. The Ups and Downs of Securities31

BY FRANCIS W. HIRST

In the first place the value of a security depends mainly upon a quality which a bale of cotton or a ton of coal does not possess. It is either actually or potentially interest-bearing. This quality is visible in a bond with coupons attached. A bond like that bought by subscribers to a Prussian state loan will have attached to it quarterly or half-yearly coupons, which can be cashed in almost any great center of finance. If the government promises to redeem the bond at the end of a definite period at par, at its maturity the bond will be worth par. In the meantime it will rise and fall according to the conditions, first of German credit, secondly of the international rate of interest. But these tendencies may be wholly or in part counteracted by antagonistic movements of an international character, for instance, a great war which destroys a vast amount of capital and absorbs vast quantities of savings. But the Prussian bond is not likely to fluctuate much, and the limits of its fluctuations will be the more restricted the more nearly it approaches its maturity. Thus the value of a security depends mainly upon (1) the rate of interest, (2) the safety of the principal, and (3) the likelihood of the principal or the rate of interest either rising or falling. These are the main causes of a rise or fall in securities.

But the business of the stock exchange operators is to endeavor to forecast and discount in advance the natural fluctuations of intrinsic value. In the old days before the telegraph, fortunes were made by getting early information, or spreading false information

31Adapted from The Stock Exchange, pp. 199–210. Copyright by Henry Holt & Co. and Williams & Norgate, 1911.

of victories and defeats, which would enhance or depress the price of stocks. The first Rothschild laid the foundations of his immense fortune by getting early news of important events. Nowadays the principle is still the same, but the art of anticipation has been made much more doubtful and complicated. Telegraphs and telephones are open to all. What everybody reads in his morning paper is of no particular use to anybody in a speculative sense. Besides, many foreign governments keep large funds in London and Paris for the express purpose of supporting the market. Hence in the market for government bonds, big movements are rare.

When we come to the prices of railroad and industrial stocks the causes of movement are much more difficult to detect, and the possibilities of making large profits by inside knowledge is much greater. The newspapers may be the conscious or unconscious tools of the manipulators. In new countries the banks are likely to be a working part of the speculative machinery. Thus in the United States those who use great fortunes in finance frequently have a controlling interest in a bank. What is called a "community of interest" may be established which will control important railroads and huge industrial corporations, as well as a number of banks and trust companies. The various ways in which such a community may manipulate a susceptible market like Wall Street might be made the subject of a long and fascinating volume.

Suppose that a powerful group wishes to create the appearance of a general trade depression in the United States. To do so is not at all impossible. The controlled railways may announce and even partially carry out a policy of reduced orders for rails, equipment, and repairs. They may ostentatiously proclaim an addition to the number of idle cars. Well-disciplined combinations of steel and textile mills may declare a curtailment of production. Banks may suddenly become ultra-conservative; the open accounts and credits of small speculative customers may be closed. In this way a general feeling of despondency can be created. Stocks will fall, partly in consequence of the action of the banks, causing a compulsory liquidation of speculative accounts, partly through the voluntary action of speculators who think that trade, earnings, profits, and dividends are likely to decline. Thus a bear market is created. The syndicate can now employ huge funds to advantage in profitable purchases of those stocks and shares which fall most and are most responsive to ups and downs. Such a policy of course represents great difficulties and dangers. It must be carried out very cautiously and very secretly, and very honorably as between the members. If it is too successful it may create a slump, or a panic, in which the community of interests

may itself be seriously involved. For these and other reasons American operators and manipulators do not frequently enter upon a concerted plan for colossal bear operations. Such a scheme is unpopular. It offends public sentiment. A long bearish movement, accompanied by unemployment, reduced earnings, and economies in expenditure, produce all manner of unpleasant consequences, economic, social, and political. In fact big men often boast that they never operate upon the short side, never play for a fall.

Such a movement as that sketched above is comparatively rare, cautious, and temporary. Wall Street has of course to wait upon circumstances. Sometimes it is caught by the circumstances. But it must always try to adjust itself to economic and political conditions. A political assassination, a war, a movement against the trusts, unfavorable decisions in the courts, an unexpected downfall of the favorite political party, a catastrophe like the San Francisco earthquake-such events as these may produce an irresistible flood of liquidation against which the strongest combination of bankers and corporation men will struggle in vain. In a general scramble produced by some unexpected event there is more likely to be a general loss than a general profit. For in the history of speculation the unexpected event is usually a calamity.

Real prosperity is built up gradually. The stock exchange anticipates and exaggerates it, until the speculative fabric has been reared so high above the real foundation that a crash is seen to be inevitable. Generally speaking, because of superior knowledge, the insiders are able to unload at high levels, just as they have been able to load at low levels. So, by speculating in stocks of a national size and significance, the outside public loses more than it gains. It begins to buy when they are dear, and it begins to sell when they are cheap.

For purposes of scientific analysis we may rest the theory of stock exchange quotations upon a distinction between prices and values. Prices are temporary; values are intrinsic; they move slowly. The price represents the momentary market value of a stock or bond. The value is the real worth, a thing undefinable and impossible to ascertain. If the real value were ascertainable and available to the public then price and value would be identical, and in the case of giltedge securities, the two are as nearly as possible identical. But intrinsic values themselves change like everything else in the world. They depend mainly upon (1) the rate of interest, (2) the margin of surplus earning power or revenue.

Both stocks and bonds are also affected in their intrinsic value by the money market and the relationship of the supply of capital seeking investment to the demand for capital by new flotations. The