Hedge (finance)

For other uses, see Hedge (disambiguation).

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A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.

A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century^[1] 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.

Etymology

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s. ^[2]

Examples

Agricultural commodity price hedging

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 greatly 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 at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, 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 to a specified place on a certain date in the future for a certain fixed price. The farmer 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 1,000 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 put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.

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, increases by 10%, while Company B increases by just 5%:

• Long 1,000 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: $1,000
• Day 2: $1,100
• Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):

• Day 1: −$1,000
• Day 2: −$1,050
• Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 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 Employee Stock Options

Employee Stock Options are securities issued by the company generally to executives and employees. These securities are more volatile than stock and should encourage the holders to manage those positions with a view to reducing that risk. There is only one efficient way to manage the risk of holding employee stock options and that is by use of sales of exchange traded calls and to a lesser degree by buying puts. Companies discourage hedging versus ESOs but have no prohibitions in their contracts.

Hedging fuel consumption

Main article: Fuel hedging

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 U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina.

Types of hedging

Hedging can be used in many different ways including foreign exchange trading.^[3] 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.

Hedging strategies

Examples of hedging include:

• Forward exchange contract for currencies
• Currency future contracts
• Money Market Operations for currencies
• Forward Exchange Contract for interest
• Money Market Operations for interest
• Future contracts for interest

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 of simulating being long on 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 foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign 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 common 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

There are varying types of risk that can be protected against with a hedge. Those types of risks include:

• Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.^[4]
• Credit risk: 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, an early market developed between banks and traders that involved selling obligations at a discounted rate.
• Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.
• Interest rate risk: the risk that the relative value of an interest-bearing liability, 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 risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.
• Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.
• Volumetric risk: the risk that a customer demands more or less of a product than expected.

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, futures are shorted when equity is purchased, or long futures when stock is shorted.

One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures.

Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades).

Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.

Futures hedging

Investors who primarily trade in futures may hedge their 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. To hedge against a long futures trade a short position in synthetics can be established, and vice versa.

Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.

Contract for difference

Main article: 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. Consider a deal between an electricity producer and an electricity retailer, both of whom 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 (FRA): A contract agreement specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract.
• 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 used only where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. As the name suggests, NDFs are not delivered but 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 provides 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 a person had invested in the same opportunity in the original currency.
• Hedge fund: A fund which may engage in hedged transactions or hedged investment strategies.

See also

• Arbitrage
• Asset-liability mismatch
• Diversification (finance)
• Fixed bill
• Foreign Exchange Hedge
• Fuel price risk management
• Immunization (finance)
• List of finance topics
• Option (finance)
• Spread

Accountant views

• IAS 39
• FASB 133
• Cash flow hedge
• Hedge accounting

References

1. ^ "A survey of financial centres: Capitals of capital". The Economist. http://www.economist.com/node/168334. Retrieved 2011-10-20. 
2. ^ "Online Etymology Dictionary definition of hedge". http://www.etymonline.com/index.php?term=hedge. 
3. ^ "Forex hedging explained". http://www.forexpromos.com/forex-hedging-tips-explained. 
4. ^ Jorion, Philippe (2009). Financial Risk Manager Handbook (5 ed.). John Wiley and Sons. p. 287. ISBN 9780470479612. 

External links

• Guide to Hedging Interest Rate Risk
• Basic Fixed Income Derivative Hedging Article on Financial-edu.com
• Hedging Corporate Bond Issuance with Rate Locks article on Financial-edu.com
• The curious moral paradox of Hedging, and how Regulation gives it a blank cheque on theotherschoolofeconomics.org