Does Hedging Produce Competitive Advantage?

A review of George Szpiro’s 2011 book on the history of the Black-Scholes option-pricing formula uses Southwest Airlines’famous fuel-price-hedging strategy as a key piece of its explanation for why firms might want to use options. Southwest’s hedging has received a lot of attention; the gains and losses on these financial trades have rivaled operating profits and losses on its income statement. Most commentators have applauded this aggressive trading activity, merely cautioning that sometimes Southwest guesses wrong about future oil prices and loses a lot of money.

What no one seems to ask is why Southwest shareholders would want the firm to be speculating in the fuel market in the first place. Unless these hedges materially reduced the risk of bankruptcy–and Southwest’s balance sheet is typically stronger than its rivals’–the classic argument applies: Shareholders should not want corporate managers to hedge industry-specific risks, such as swings in fuel prices, because they can very easily deal with these risks themselves by holding a diversified portfolio of stocks (including oil firms) or even by buying their own options on oil prices. Southwest’s financial risk reduction via hedging conveys little or no benefit to the owners of the firm.

But wait, many will object–doesn’t hedging give Southwest a cost advantage over its rivals when oil prices go up? And since these hedges are often accomplished by options, isn’t there an asymmetry, since when Southwest guesses wrong, it only loses the price it paid for the option? Doesn’t the airline therefore lower its costs by these trades, gaining a leg up on its rivals?

The answer is No. These hedges have no impact whatsoever on Southwest’s cost of being an airline operator. They constitute an independent, speculative financial side business, a business that is exactly as good for Southwest shareholders as the CFO’s team is at outguessing the fuel market. Even when Southwest guesses right, it is not improving the airline business’s competitiveness.

To see why this is true, think about the incremental fuel cost to Southwest of running a flight with or without the hedge. If the spot price of fuel is $x/gallon at the time of the flight and it consumes y gallons, then the fuel cost is xy. If Southwest has successfully hedged the oil price, then it will make a bunch of money after closing out its position, but it would still independently save $xy by not running the flight. If Southwest has guessed wrong and lost money on the hedge, it would also save $xy by not running the flight. So the cost of operation–the increment in expenditure caused by producing another unit–is unaltered by the hedging strategy.

This situation should be easy to visualize because the hedges are on oil rather than jet fuel and because they are settled for cash rather than physical delivery. But even if the hedges were denominated in physically delivered jet fuel, successful or unsuccessful hedging would have no impact on airline operating costs. If Southwest just bought fuel early for $(x-a)/gallon and stored it until the spot price was $x/gallon, the opportunity cost of the flight would still be $xy, since the airline could cancel the flight and sell y gallons for that amount. The incremental expenditure difference between flying and not flying is exactly the same. (If opportunity cost confuses you, visualize that Southwest has some fuel on hand purchased at the lower hedged price and some at the spot price, and note that it doesn’t matter which barrel of gas goes into which plane–all the fuel is fungible, and it is all worth $x/gallon if that’s what it could be sold for.)

Now, risk-averse behavior by managers may be in their own interest, depending on the form of their compensation, the structure of the labor market, and their perceived ability differential over their peers. But it is of little help to the owners of public firms that are far from bankruptcy. That’s a point that should not be hedged.

McKinsey Quarterly Top 10 of 2012

The McKinsey Top Ten Articles of 2012 (registration required) contains a few items of interest for strategy folks.

First, it looks like the “s-word” is coming back into style in the endless wheel of business language faddism. Four of the articles have strategy in the title, and some of the others make heavy use of the term in the text. Birshan and Carr in “Becoming More Strategic” say

We are entering the age of the strategist. As our colleagues Chris Bradley, Lowell Bryan, and Sven Smit have explained in “Managing the strategy journey,” a powerful means of coping with today’s more volatile environment is increasing the time a company’s top team spends on strategy. Involving more senior leaders in strategic dialogue makes it easier to stay ahead of emerging opportunities, respond quickly to unexpected threats, and make timely decisions.

Second, we have Cynthia Montgomery’s rumination on “How Strategists Lead,” which makes a decent complement to Dick Rumelt’s Good Strategy, Bad Strategy and is based on a forthcoming book. It’s mostly wisdom-talk, but of a refreshingly skeptical and thoughtful type that fits many of my prejudices, so I’m endorsing it. One part that will be of interest to many of our readers is her insight that since going into executive teaching she’s found that her students are largely incapable of allowing their analyses to temper their optimism or to link their business plans to their analysis of competitive forces. We want executives with a can-do spirit, but we also want executives who are good at the Serenity Prayer and have the wisdom to know the difference between the things they can change and the things they cannot.

Third, we have “How Leaders Kill Meaning at Work,” worked up from a 2011 book, which is based on a large diary study (“…nearly 12,000 daily electronic diaries from dozens of professionals working on important innovation projects at seven North American companies.”). The article is based on “entries in which diarists mentioned upper- or top-level managers—868 narratives in all.” It turns out that “killing meaning” is equivalent to “interfering with success on projects and thereby demoralizing team members,” so the worker-motivation angle isn’t really necessary to their catalogue of upper-management dysfunction. The main quibble I have with the article is that they make no allowance for the possibility that experimentation and/or creating options might be the right way to go, although in the examples they give, if that was what was going on, communication with the front-line troops was inadequate.

All in all, might be worth registering for.

Neuroeconomic imperialism?

I just saw a recent article in the Chronicle of Higher Education on the emerging field of neuroeconomics. Unlike behavioral economics, where ideas from psychology have been ported over to economics to explain various individual “anomalies” in choice behavior, in neuroeconomics much of the intellectual traffic has gone in the other direction–economic modeling tools are helpful in understanding psychological processes (including where those processes deviate from classic economic theory). The axiomatic approach to choice makes it a lot easier to parse out how the brain’s actual mechanisms do or don’t obey these axioms.

An important guy to watch in this area is Paul Glimcher, who mostly stays out of the popular press but is a hardcore pioneer in trying to create a unified (or “consilient”) science encompassing neuroscience, psychology, and economics. I’ve learned a lot from reading his Foundations of Neuroeonomics (2010) and Decisions, Uncertainty, and the Brain (2004): why reference points (as in prospect theory) are physiologically required; how evolutionary theory makes a functionalist and optimizing account of brain behavior more plausible than a purely mechanical, piecemeal, reflex-type theory; why complementarity of consumption goods presents a difficult puzzle for neuroscience; and much more.

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In the mail: The Wide Lens: A New Strategy for Innovation, by Ron Adner

Ron Adner is a colleague and long-time friend at Dartmouth’s Tuck School. This practitioner-oriented book is based upon his highly original research on innovation. More when I have had a chance to read and digest.

In the mail: Guitar Zero: A Neuroscientist Debunks the Myth of “Music Instinct”

When you read this, you realize just how little we really know about learning. Major implications for the study of strategy, of course. But, also, a glimmer of hope that I may one day pursue that long-abandoned rock career. Article here: Guitar Zero: A Neuroscientist Debunks the Myth of “Music Instinct” | Brain Pickings. Book here.

Mastering Strategic Management

I have to be careful with this post as four-five good friends have written textbooks in strategy — all of them, I’m sure, are excellent.   So, Flat World Knowledge now has a strategy textbook forthcoming, Mastering Strategic Management.   Flat World’s model is to deliver a low-cost alternative to existing textbooks: online access to the textbooks is free and then a fee is charged for downloading (and there are also audio versions etc).

I haven’t personally used a textbook in my teaching for six-seven years.  I frankly prefer the flexibility that comes from putting together a set of readings that fits my own teaching style and agenda.  But, it is nice to see additional alternatives popping up for teaching.  Flat World Knowledge also has a Principles of Management, Organizational Behavior and an International Business textbook.

Strategy and social movements

For a sociological approach to strategy, check out the work of sociologist James Jasper.  Jasper studies strategy in the context of social movements.

Here are a few pieces that readers might enjoy:

Reality distortion field and strategy

I’ve been reading the new Steve Jobs biography and I find the possibilities of the “reality distortion field” quite promising for strategy (well, we do have lots of research on “framing” that indeed relates).  When I worked in venture capital, I saw lots of entrepreneurs try to distort reality, some successfully, many not.  Perhaps more on the RDF concept once I’ve finished the 571-page book.

Here’s Dilbert poking fun (click below).  The use of superlatives (particularly by Jobs) in Apple product launches was simply ridiculous – but, in the end, his spell seems to have worked on many (including me: I use a lot of Apple products). Read the rest of this entry »

Grand strategies

I’ve been reading Charles Hill’s (Yale) book Grand Strategies: Literature, Statecraft and World Order.  The book is rather aggressive. It is essentially an effort to provide a tutorial for how big-picture thinking and decision-making at the global level might be informed by literature, specifically the classics.

The premise of the field of “grand strategy” (essentially an off-shoot of political science and history) is that this type of practical big-picture thinking–strategic decisions under uncertainty–can’t be taught and understood by focusing on the minutiae that extant social science studies.  Well, that’s the story anyways.  So, in this book Hill turns to the classics.

Throughout the book Hill discusses the influence that specific classics have had on various leaders (Leaves of Grass and Lincoln, The Dream of the Red Chamber and Mao, Don Quixote and Mann, etc) and also vets the analogies between fictional events and narratives in the classics and real-world correlates.  You get sort of a dazzling history of modernity (post Thirty Years’ War), where various classics essentially provide possibilities, foreshadow or mirror emergent realities about wars, nation states, forms of governance, etc.   The result is a pretty breath-taking tour de force where fiction and reality blend all too readily.  Hill’s book seems to imply both a great man theory as well as a (Campbellian, of sorts) great narrative(s) theory of, well, everything.  I should note – Hill’s political stripes are pretty evident from the book, so that might bother some readers.

But I am really enjoying the book.  I’m of the mind that the classics indeed have much to teach us, strategy included.  I would recommend this book over most of the practitioner strategy books that you might pick up at your local bookstore.

I’ll put up another post about the book once I finish it.

Here are some reviews of the book – WSJForeign AffairsOpen Letters Monthly.

Bonus material:

Here’s a paper by John Gaddis on “What is Grand Strategy.”  John Gaddis lecture on “What is Grand Strategy?” Here’s a shorter Foreign Policy piece on “what is grand strategy and why do we need it?

Below the fold you’ll find a video of Charles Hill speaking about the above book. Read the rest of this entry »