segregate unrealized gains/losses - week 4
October 3, 2022
Last week I discussed the difference between GAAP accounting standards and the economics of hedges. When I was managing a risk portfolio my biggest frustration was the month-to-month accounting for derivatives. When a hedge is placed, there is a physical (or in some cases a derivative) offset. So, the “marked-to-market” gain/loss on the derivative should be offset by the physical. That’s how the hedge was designed. But it all depends on the accounting treatment.
If a company qualifies for and has adopted strict “hedge accounting,” then the month-to-month changes in the derivative side of the hedge is parked on the balance sheet, not the P&L. When the product is produced or sold, and the derivative is closed out, the “realized” gain/loss on the derivative is matched up with the offsetting gain/loss on the physical, and the net results are posted to the P&L. If the hedge is “effective,” the margin identified before the hedge was placed should be very close to the actual margin calculated when the hedge was closed out.
But not every company adopts strict hedge accounting. The “unrealized” gain/loss on derivatives are totaled up into one giant gain or loss and reported on that month’s P&L. It appears that all the volatility in the market is bleeding into the P&L. If the market is moving in the opposite direction, the month-to-month losses before a contract expires can be significant. That is when the accounting/finance department will calculate losses and the risk manager will take the hit. Why, the CEO may ask, did you not forecast this price trend before putting on the hedge? The answer of course is you can’t realistically forecast commodity prices and that’s exactly why the company adopted risk management practices.
Until a contract expires, any “unrealized” gains or losses reported on the P&L should be set aside for consideration later. If when the contract expires the physical gain/loss offset the derivative gain/loss, then all is good in risk management land. It was an effective hedge. If the company is adverse to future swings in derivatives and wants to avoid the P&L impact, they can either 1) not adopt risk management and swing with the market, 2) adopt strict hedge accounting rules, or 3) purchase out-of-the money put/calls to offset any potential large future swings in unrealized losses. But don’t blame the risk manager for doing her/his job.