What is a 'Hedge'

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally,
a hedge consists of taking an offsetting position in a related security, such as a futures contract.
A hedge is an investment position intended to offset potential losses/gains that may be
incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses/gains suffered by an individual or an organization.
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 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.

BREAKING DOWN 'Hedge'

Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone
area, you will want to protect that asset from the risk of flooding to hedge it, in other words
by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it
reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the
case of the flood insurance policy, the monthly payments add up, and if the flood never comes,
the policy holder receives no payout. Still, most people would choose to take that predictable,
circumscribed loss rather than suddenly lose the roof over their head.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge
is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the
ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk
that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the
discrepancy.

Hedging Through Derivatives

Derivatives are securities that move in terms of one or more underlying assets; they
include options, swaps, futures and forward contracts. The underlying assets can be
stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective

hedges against their underlying assets, since the relationship between the two is more or less
clearly defined.

For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might
hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in
one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the
next year. If a year later STOCK is trading at $12, Morty will not exercise the option and will be
out $5; he's unlikely to fret, however, since his unrealized gain is $200 ($195 including the price
of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell
his shares for $8, for a loss of $200 ($205). Without the option, he stood to lose his entire
investment.
The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the
"hedge ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the
price of the underlying asset.

Hedging Through Diversification

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a
measure of sophistication and often quite a bit of capital. Derivatives are not the only way to
hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be
considered arather crudehedge. For example, Rachel might invest in a luxury goods
company with rising margins. She might worry, though, that a recession could wipe out the
market for conspicuous consumption. One way to combat that would be to buy tobacco stocks
or utilities, which tend to weather recessions well and pay hefty dividends.
This strategy has its tradeoffs: if wages are high and jobs are plentiful, the luxury goods maker
might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might
fall as capital flows to more exciting places. It also has its risks: there is no guarantee that the
luxury goods stock and the hedge will move in opposite directions. They could both drop due to
one catastrophic event, as happened during the financial crisis, or for unrelated reasons: floods
in China drive tobacco prices up, while a strike in Mexico does the same to silver.

Elective 5 TREASURY MANAGEMENT

07/27/16

ESCOBAR, FRANZELYN LIM