Inflation, Convexity, and Hedging

How rising inflation is (partially) down to poor risk management

Finance is tail risk hiding. With exceptions of course. Nassim Nicholas Taleb, November 15 2021, (via Twitter)

Last week, I was discussing the drivers behind the recent spike in inflation with Shane O’Neill, our head of interest rate trading. Now, I lean towards the view that current inflationary pressures are not transitory and will be driven by monetary and fiscal largesse. However, I also recognize that supply-side constraints are a catalyst in the transition from a deflationary to an inflationary environment, and our conversation turned to the vulnerability of global supply chains acting as a source of inflationary pressure.

So, why are global supply chains so vulnerable that the COVID crisis has led to inflation levels not seen for three decades? A recent Twitter thread from Ryan Petersen, the CEO of Flexport, a supply chain management business, linked the supply chain drivers of inflation to one of the key tenets of modern finance, our obsession with Return on Equity (ROE). Petersen makes the point that our fixation with efficiency and optimization has ‘stripped the shock absorbers out of the economy in pursuit of better short-term metrics’. He gives examples such as just-in time supply chains, asset-light business models, and shrinking R&D budgets. In other words, a single-minded focus on optimizing our supply chains has inadvertently made them weaker. When an unexpected event such as COVID hits the economy, we are unable to cope, leading to inflationary supply chain bottlenecks.

This analysis is compelling and relevant to a risk management company like Validus, as our job is to make sure our clients are protected against exposure to market risks. This often involves hedging, and Petersen’s comments highlighted two common (and related) pitfalls that can plague both supply chains and hedging programmes:

1. Overoptimization: A just-in-time supply chain involves optimizing the production process to lower costs. Holding less stock in inventory can indeed bring down costs (and increase profits), but the ‘hidden’ cost of this optimization is increased vulnerability to extrinsic shocks, like a global pandemic. Similarly, one of the biggest mistakes made when designing a hedging program is to over-optimize the program based on a specific objective (again, hedging costs are a common one), whilst ignoring potential exposure to secondary or tertiary risks (e.g., liquidity risk, credit risk).

In fact, one of the most infamous hedging disasters in history (Metallgesellschaft) occurred because the German conglomerate was hedging long-term oil exposure with short-term futures contracts to minimize hedging costs. The strategy (and the company) blew up when the liquidity mismatch between the hedge and the exposure became too large to manage. Overoptimization can create dangerous vulnerabilities.

2. A lack of convexity: Convexity means being positively exposed to extreme events, a concept popularized in N.N. Taleb’s 2013 book ‘Antifragile: Things that gain from Disorder’. The inverse of convexity, concavity, means to be negatively exposed to extreme events. Hyper-optimized supply chains have shown themselves to negatively exposed to unexpected events like the COVID crisis. In contrast, a ‘convex’ supply chain would be one that benefits from such ‘tail events’ - for example a company which has several options (e.g., alternative suppliers, plant locations etc.) when it comes to sourcing goods and raw materials might benefit from systemic supply chain disruptions - the company could, for example, increase market share at the expense of its hyper-optimized peers.

Similarly, when it comes to risk management, it is often a good idea to incorporate convexity into a hedging strategy. Just like a convex supply chain involves having ‘options’ when it comes to sourcing product, the most effective way to do this in the context of hedging is to buy derivatives which have embedded optionality (e.g., interest rate caps, FX options) to ensure the hedging portfolio is ‘long volatility’ and actually benefits from the occurrence of so-called black swan events. This does not mean a hedging portfolio needs to be constructed only of options, but an assessment of the hedging portfolio’s ‘convexity’ is a valuable exercise.

(Over)optimization and convexity are related concepts, and both are critical considerations when it comes to designing and implementing supply chain and financial hedging strategies. In a world where black swan events are inevitable, strategies which can cope with, and indeed benefit from, such events can be incredibly valuable. After all, in both the real world and in financial markets, most risks come from the fat tails!