Last week, I was having one of those fateful (although not on this particular occasion) post midnight MSN conversations, I (half) tried to explain this concept, and it turned out really badly. Then, on Friday, someone said something to me that brought it up again in my mind. I suppose, given the number of times that I practised the proof of the concept for one of my exams, it's really no surprise that it keeps coming up in my head.
As it happens, certainty of cash flows is a big deal in finance, and in particular in the area of risk management. There are obvious reasons for this, like that it helps with financial planning etc, and also less obvious reasons, like that reducing the variance of cash flows means that you can reduce expected tax (think Modigliani-Miller and such). To create greater cash flow certainty, financial managers, and indeed anyone else who feels like it, use a hedging strategy. Hedging strategies commonly involve the purchase (and, generally, sale) of financial derivatives (e.g. futures, forwards, options) so as to give the hedger a price that they are happy with over the volume of whatever the underlying asset they're interested in is.
For example, imagine that I have a business which sells mozzarella cheese (when I was about 14, I had a friend who didn't know how to say my last name, so he called me 'Emma Mozzarella'). The current price of mozzarella cheese is $50/kg , but I am worried that the price will fall to $30/kg in two months' time, when I have to sell it. The current price of a two month mozzarella cheese futures contract is $40/kg (lower than the current price, reflecting the expectation that the price will fall). Therefore, to hedge against the predicted price fall to $30, I sell a two month futures contract at $40. This gives an immediate cash inflow of $40.
One of two things can happen from here.
The first situation that could occur is that my expectations are correct, and the price of mozzarella does fall to $30/kg. Therefore, when I close out my futures position by buying a futures contract in two months' time, at $30kg (the market price = futures price at maturity), I make $10 profit (as I initially sold at $40 and bought at $30). Therefore the price that I receive at maturity for my mozzarella is $30+$10=$40, and, happily, I have protected myself from the extent of the price fall, by hedging at $40 so that I don't have to receive $30 in the market at maturity. What a thrill.
However, sometimes what people expect will happen does not always turn out to be the case. Let's say that I had been living in my own little world, forming my own unobjective and narrow-minded views about the price of mozzarella cheese. Let's say that, having hedged by selling two month mozzarella futures at $40/kg, the price of mozzarella actually increases to $60/kg. Therefore, I sell at $40 (as detailed above), and buy at $60/kg (I buy because I have to close out the futures market position by doing the equal and opposite of my original selling position, and it is at $60/kg as at maturity, spot price = futures price). I make a $20 loss (having sold at $40 and bought at $60).
So I guess the point of my mundane mozzarella example is to say that certainty is not always a fantastic thing. Certainty has a cost. In the second example, even though there is certainty, and I am better off than I thought that I was going to be, I can never be as well off as I could have been, had I not hedged. Because I chose the certainty of $40/kg, it means that when the market turned up, I couldn't take advantage of the $60/kg price.
Life is a bit like this too. We see certainty as a good thing and are always trying to achieve it, if we're unlucky, then this 'certainty' isn't necessarily the great thing that it's cracked up to be.
That said, if/when I do end up in the second position, I shouldn't be too unhappy. After all, I chose the $40.
I could hear Cheryl's voice when reading certain parts of this post :P
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