Imagine you just walked into your local grocery store and the store manager said to you, "Congratulations, you've just won USD60 which will be mailed to you in a month's time. However, if you don't want the wait, you could choose instead to take USD50 cash now." Since you didn't want the hassle of waiting and filling out forms, you happily took the instant reward.
Now, imagine if the manager had said this instead, "Congratulations, you've just won our lucky draw. We will mail you USD60 in 6 months' time. However, if you want to shorten the wait, you could opt for USD50 to be sent in 5 months' time." Which one would you prefer now?
Time-inconsistency in discounting
According to behavioural research, it is found that many people would prefer USD50 now to USD60 in a month, but very few people would prefer USD50 in 5 months to USD60 in 6 months. However, the two questions are actually the same, except that in the second scenario, it was asked 5 months earlier.
This inconsistency in preferences is in a direct conflict with standard financial theories. For example, an IRR is calculated by assuming cash flows have an internal rate of return constant over time. Indeed, using standard net-present-value (NPV) calculations assuming some discount rate, people should have preferred the same decision in both scenarios.
This is a well-researched phenomenon in behavioural science called "hyperbolic discounting," based on the empirical observations that our mental valuation of reward falls rapidly with relatively short periods of delay but only slowly for longer periods of delay.
Is hyperbolic discounting irrational?
Hyperbolic discounting can be used to explain why humans prefer instant gratification and seek to delay any cost or effort to the future, i.e. we procrastinate.
Back in the days when humans lived in caves, these tendencies were probably helpful for survival because resources were scarce and lives were uncertain.
Hyperbolic discounting can be used to explain why humans prefer instant gratification and seek to delay any cost or effort to the future, i.e. we procrastinate / that investors favour stability over uncertainty and do so by penalising riskier companies with higher discount rates and hence lower valuations.
However, in modern society, the same tendencies seem to backfire on us in many places. For example, we might prioritise watching the new TV series and eating the ice cream now, rather than studying a foreign language or going to the gym. It is easy to see how "overvaluing" instant reward/cost but "over discounting" future ones can be a detriment to decision-making.
Problem of hyperbolic discounting in risk management
In the first article of the Rethinking Treasury series, we discussed that investors favour stability over uncertainty and do so by penalising riskier companies with higher discount rates and hence lower valuations.
However, stability as a virtue can only be observed or realised in the longer term and due to mental hyperbolic discounting, it may not get the importance it deserves or can sometimes be overlooked.
On the other hand, also due to the hyperbolic discounting, the upfront costs of carry that can come with hedging activities felt a lot more tangible and caught our attention instead.
Focusing on near-term costs rather than long-term benefits could sometimes tilt the balance and lead to some sensible hedging decisions not being carried out.
Compounding the problem is our inability to predict how we will react in a hypothetical future scenario. This is because the full emotional impact of future experiences are hard to anticipate. We will explain "affective forecasting" in more detail next month.
One practical solution to hyperbolic discounting: a "forward-start" approach
As with other behavioural biases, being aware is always the necessary first step to better decision-making. The second step, which is finding the right solution, however, does not always have to be about suppressing our hardwired predispositions.
Last month in the ninth article of the Rethinking Treasury series, we discussed regret as an emotion evolved through millions of years due to its functional use. Therefore, rather than minimising volatility, one could seek to optimise around minimising regret. We also found some success in machine learning analytics using this metric.
Similarly for hyperbolic discounting, we could factor it into our decision-making process so that the end solution may sit well with our intuition. One such approach is the "forward-start" approach.
A forward-start hedge is a hedge with a delayed onset. Therefore, any negative carry will not be incurred until the first settlements which can be a number of years away. This strategy of deferring hedging costs can potentially ameliorate our hyperbolic discounting bias as cost and benefit are better aligned on a time scale.
It also turns out that a forward-start approach can be especially useful for interest rate hedging where future volatility, which can be a larger risk component than near term rate volatility, is being managed. (We will discuss more about risk contribution in more detail in future articles.)
Key takeaway for CFOs and treasurers
Hyperbolic discounting and affective forecasting are two sources of behavioural biases that can lead to suboptimal decision-making. One common consequence is the under-hedging of exposures, especially when a carry cost needs to be incurred.
Fortunately, the carry costs of hedging in many markets have come down recently. In certain markets, the carry may have even flipped from cost to benefit. In these situations, both objectives of "improving carry" and "de-risking" can be aligned. This can make hedging decisions easier to carry out.
In cases where the costs may be harder to justify (even after correcting for hyperbolic discounting biases) but a hedging decision is still deemed necessary for risk management purposes, a forward-start or a deferred-premium approach can be considered.
The bottom line remains that hyperbolic discounting creates a systemic bias in decision-making. Recognising the bias is the first step. Using the analysis developed from standard financial theory is a good way to combat the prejudice. The quantitative or modelling approach to quantify risks, costs and benefits is a practical way of applying financial theory. Your financial partner can help to set up this analysis.
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