Hedge (finance)
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.
Hedge (finance) 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.
Hedge (finance)
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.
Hedge (finance)
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.
Hedge (finance)
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.
References
[1] [2] [3] [4] "A survey of financial centres: Capitals of capital" (http:/ / www. economist. com/ node/ 168334). The Economist. . Retrieved 2011-10-20. "Online Etymology Dictionary definition of hedge" (http:/ / www. etymonline. com/ index. php?term=hedge). . "Forex hedging explained" (http:/ / www. forexpromos. com/ forex-hedging-tips-explained). . Jorion, Philippe (2009). Financial Risk Manager Handbook (5 ed.). John Wiley and Sons. p.287. ISBN9780470479612.
External links
Guide to Hedging Interest Rate Risk (http://www.accountingmajors.com/accountingmajors/articles/ interest-rate-hedges.html) Basic Fixed Income Derivative Hedging Article on Financial-edu.com (http://www.financial-edu.com/ basic-fixed-income-derivative-hedging.php)
Hedge (finance) Hedging Corporate Bond Issuance with Rate Locks article on Financial-edu.com (http://www.financial-edu. com/treasury-rate-lock-agreement.php) The curious moral paradox of Hedging, and how Regulation gives it a blank cheque on theotherschoolofeconomics.org (http://www.theotherschoolofeconomics.org/?p=1036)
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