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    After years of natural selection, our human brain is optimised for survival, using our ability to navigate the complex world by instantly assessing risks and rewards. That said, there still remains a much stronger bias against risk, as after all, we can only live once.

    How Did Primitive Humans Survive Uncertainty

    On the African savannah of 100,000 years ago, our hunter-gatherer ancestors faced many situations involving risk and reward. "Should I reach for those ripe berries across the field with a lion lurking just 50 meters away?" Probably not. What if the lion is actually 5 kilometres away? What if the lion is 50 meters away but is deep asleep? What if my family had been starving for days? A hunter-gatherer, paralysed by all these thoughts, may have become too slow to act and see those ripe berries pecked away by birds. On the other hand, those hunter-gatherers who would happily go for the berries every time without regard to the lions would likely have exited the gene pool very quickly.

    After years of natural selection, our human brain is optimised for survival, using our ability to navigate the complex world by instantly assessing risks and rewards. That said, there still remains a much stronger bias against risk, as after all, we can only live once.

    We discussed in our second article of the Rethinking Treasury series that regret is a powerful emotional driver for decision making. To help us survive, our brain is hardwired to avoid the potential for large regret. "If I go for those berries, I may lose a limb as I may be chased by the lion and I would regret this for life." So the hunter-gatherer wisely stays put.

    The Treasurer's Conundrum

    Borrowing from the famous philosophical argument, Pascal’s Wager, developed in the 17th century, we can adopt the same logical framework to treasury hedging decisions. Let’s call this the "Treasurer's Conundrum."

    1. There are only two alternatives possible – either the market will move in my favour, or against
    2. There is no way to know for sure which alternative will be true, but a choice must be made
    3. A rational person would decide as follows:
      • Assuming the market will definitely move in my favour – "Don't hedge anything at all"
      • Assuming the market will definitely move against me – “Hedge everything completely"
    4. But there is always uncertainty – hedging completely or not hedging at all both have equal potential for regret.

    From a theoretical corporate finance perspective, only un-diversifiable risks can generate positive expected returns above the risk free rate. Therefore, any risks that can be hedged or diversified away in the market are not productive and do not generate any value for the company. This therefore supports a maximum risk reduction approach.

    However, from a practical perspective, corporates consist of real people making hedging decisions and peoples’ decisions can be influenced by emotions, in particular the desire to avoid regret, especially when this can be measured and judged by others. It is not uncommon to see risk managers, having gone through the steps of the "Treasurer's Conundrum," decide that inaction is the optimal strategy. Whilst the economic chance of regret is not necessarily reduced, it is far harder to record and measure the impact of inaction, leading to a potential bias against positive hedging action.

    Another approach commonly taken is to hedge 50 per cent of the risks. Intuitively, this is appealing as it serves to minimise potential regret by diversifying between two extreme alternatives. It is probably for this reason, many corporates set their hedging ratios in the range of 40-60 per cent in their hedging policy.

    We define the "regret" of a given hedging strategy as the performance deviation from that which would have been achieved using the best strategy with perfect hindsight.

    Looking at the Treasurer's Conundrum through the Lens of Regret

    Regret minimisation could be viewed as a flaw in our logical thinking process. It can either lead to inaction where action should be taken, or distract attention from the more fundamental objective of reducing net volatility, by leading to over-focus on the outcome of any individual hedging decision. However, regret minimisation has also been naturally selected through millions of years of evolution and will always influence the human decision making intuition.

    Given this, perhaps the concept of regret can be introduced as a parameter in the decision making process. To illustrate the concept, let’s take an example of a company that needs to buy USD in 6 months’ time to hedge a foreign currency payable and wants to compare various different hedging strategies

    In this example, we define the "regret" of a given hedging strategy as the performance deviation from that which would have been achieved using the best strategy with perfect hindsight. Therefore, the "regret" for any given strategy can only be zero or negative. The charts below plot the “regret” score for each strategy using historical data of USD/CNH over the last 7 years.

    In this case, visual inspection will help indicate which strategy may perform the best for this specific definition of “regret,” but the concept can be used much more widely to supplement the decision-making process. For example, a more tailored definition of regret could be introduced whereby regret is only felt, and therefore measured, if they are 3 per cent or more. The function can be designed to fit the specific company and risk reward appetite. In other instances, we have used “squared regret” as a function that places more emphasis on episodes with larger regrets.

    This analysis can have application in a corporate’s digital strategy. We have successfully implemented machine learning algorithms to allow a computer to “learn” what strategies would lead to the least cumulative regret after a certain number of trials. (We will discuss this in more detail in our new Digital Series to be launched later this year).

    Key Takeaways for CFOs and Treasurers

    The Treasurer's Conundrum is a real practical dilemma faced by risk managers when it comes to hedging decisions, because a choice must be made. Not hedging is still an active “choice” being made and it relies on the market remaining stable or moving in the company's favour. The Treasurer’s Conundrum, together with a strong status quo bias, leads to a classic agency problem where decision makers may leave large exposures unhedged for fear of potential regret of positive action.

    One way to break this impasse may be to use "regret minimisation" as a new lens to evaluate hedging strategies, supplementing existing decision frameworks.

    With perfect hindsight, we could extract historical data on realised regrets as fodder for machine learning algorithms to generate useful insights about hedging.

    Two ways to identify best practices for hedging - Simplified Chinese

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