Hedge (finance)

In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, many types of over-the-counter and derivative products, and perhaps most popularly, futures contracts. Public futures markets were established in the 1800s to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.

Examples

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that - forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises a lot between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.

If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time, he effectively locks in the price of wheat at that time - the contract is an agreement to deliver a certain number of bushels of wheat on a certain date in the future for a certain fixed price. He has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.

Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B.

The first day the trader's portfolio is:

Long 1000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares.) If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless. But in this case, the risk is lessened but not removed.

On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:

Long 1000 shares of Company A at $1.10 each: $100 gain
Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:

Value of long position (Company A):

Day 1: $1000
Day 2: $1100
Day 3: $550 => ($1000 – $550) = $450 loss

Value of short position (Company B):

Day 1: -$1000
Day 2: -$1050
Day 3: -$525 => ($1000 – $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge - the short sale of Company B - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

Hedging fuel consumption

Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the US rose dramatically after the 2003 Iraq war and Hurricane Katrina.

Types of hedging

The stock example above is a "classic" sort of hedge, known in the industry as a "pairs trade" due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values, known as models, the types of hedges have increased greatly.

Examples Of Hedging Strategies

This is a list of hedging strategies, grouped by category.

Financial Derivatives such as call and put options

Risk reversal Simultaneously buying a call option and selling a put option, This has the effect simulating being long a stock or commodity position.
Delta neutral This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutral strategy.

Natural hedges

Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.

Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.

One of the oldest means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.

Categories of hedgeable risk

For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.

Interest rate risk – is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
Equity – the risk, or sometimes reward, for those whose assets are equity holdings, that the value of the equity falls
Securities lending - Hedged portfolio stock secured loan financing is a form of individual portfolio risk reduction that results typically in a limited recourse loan.

Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years a huge global market developed in products to hedge financial market risk.

Hedging credit risk

Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, factoring, or discounted bill.

Hedging currency risk

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.

The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events.

As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.

Hedging equity and equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, you short futures when you buy equity. Or long futures when you short stock.

There are many ways to hedge, and one is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE futures.

Another method to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone is 2, then for a 10000 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures (the Index that Vodafone trades in).

Futures hedging

If you primarily trade in futures, you hedge your futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. So if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.

Contract for difference

A contract for difference (CFD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. For instance, consider a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price.

In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.

Related concepts

Forwards: A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
Forward Rate Agreement: A contract agreement specifying an interest rate amount to be settled, at a pre-determined interest rate on the date of the contract. This is also known as FRAs.
Currency option: A contract that gives the owner the right but not the obligation to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
Non-Deliverable Forwards (NDF): A strictly risk-transfer financial product similar to a Forward Rate Agreement, but only used where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. NDFs are, as the name suggests, not delivered, but rather, these are settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currency, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same, it's just that the supply of insured currency is restricted and controlled by government. See Capital Control.
Interest rate parity and Covered interest arbitrage: The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically gives you the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if you had invested in the same opportunity in the original currency.
Hedge fund: A fund which may engage in hedged transactions or hedged investment strategies.

External links