A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of
financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s, including
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s,
exchange-traded fund
An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the ...
s,
insurance
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
,
forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of deriva ...
s,
swaps,
options
Option or Options may refer to:
Computing
*Option key, a key on Apple computer keyboards
*Option type, a polymorphic data type in programming languages
* Command-line option, an optional parameter to a command
*OPTIONS, an HTTP request method
...
, gambles,
many types of
over-the-counter
Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid prescr ...
and
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. F ...
products, and
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s.
Public
futures market
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or fi ...
s were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural
commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a comm ...
prices; they have since expanded to include
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s for hedging the values of
energy
In physics, energy (from Ancient Greek: ἐνέργεια, ''enérgeia'', “activity”) is the quantitative property that is transferred to a body or to a physical system, recognizable in the performance of work and in the form of heat a ...
,
precious metal
Precious metals are rare, naturally occurring metallic chemical elements of high economic value.
Chemically, the precious metals tend to be less reactive than most elements (see noble metal). They are usually ductile and have a high lustre. ...
s,
foreign currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
, and
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
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 first known use of the word as a verb meaning 'dodge, evade' dates from the 1590s; that of 'insure oneself against loss,' as in a bet, is from the 1670s.
Examples
Agricultural commodity price hedging
A typical hedger might be a commercial farmer. The market values of
wheat
Wheat is a grass widely cultivated for its seed, a cereal grain that is a worldwide staple food. The many species of wheat together make up the genus ''Triticum'' ; the most widely grown is common wheat (''T. aestivum''). The archaeologi ...
and other crops fluctuate constantly as
supply and demand
In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...
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 price of wheat might change over time. 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 is going to lose the invested money.
Due to the uncertainty of future supply and demand fluctuations, and the price risk imposed on the farmer, the farmer in this example may use different financial transactions to reduce, or hedge, their risk. One such transaction is the use of
forward
Forward is a relative direction, the opposite of backward.
Forward may also refer to:
People
* Forward (surname)
Sports
* Forward (association football)
* Forward (basketball), including:
** Point forward
** Power forward (basketball)
** Sm ...
contracts. Forward contracts are mutual agreements to deliver a certain amount of a commodity at a certain date for a specified price and each contract is unique to the buyer and seller. For this example, the farmer can sell a number of forward contracts equivalent to the amount of wheat he expects to harvest and essentially lock in the current price of wheat. Once the forward contracts expire, the farmer will harvest the wheat and deliver it to the buyer at the price agreed to in the forward contract. Therefore, the farmer has reduced his risks to fluctuations in the market of wheat because he has already guaranteed a certain number of bushels for a certain price. However, there are still many risks associated with this type of hedge. For example, if the farmer has a low yield year and he harvests less than the amount specified in the forward contracts, he must purchase the bushels elsewhere in order to fill the contract. This becomes even more of a problem when the lower yields affect the entire wheat industry and the price of wheat increases due to supply and demand pressures. Also, while the farmer hedged all of the risks of a price decrease away by locking in the price with a forward contract, he also gives up the right to the benefits of a price increase. Another risk associated with the forward contract is the risk of default or renegotiation. The forward contract locks in a certain amount and price at a certain future date. Because of that, there is always the possibility that the buyer will not pay the amount required at the end of the contract or that the buyer will try to renegotiate the contract before it expires.
Future
The future is the time after the past and present. Its arrival is considered inevitable due to the existence of time and the laws of physics. Due to the apparent nature of reality and the unavoidability of the future, everything that currently ...
contracts are another way our farmer can hedge his risk without a few of the risks that forward contracts have. Future contracts are similar to forward contracts except they are more standardized (i.e. each contract is the same quantity and date for everyone). These contracts trade on exchanges and are guaranteed through
clearinghouses. Clearinghouses ensure that every contract is honored and they take the opposite side of every contract. Future contracts typically are more liquid than forward contracts and move with the market. Because of this, the farmer can minimize the risk he faces in the future through the selling of future contracts. Future contracts also differ from forward contracts in that delivery never happens. The exchanges and clearinghouses allow the buyer or seller to leave the contract early and cash out. So tying back into the farmer selling his wheat at a future date, he will sell short futures contracts for the amount that he predicts to harvest to protect against a price decrease. The current (spot) price of wheat and the price of the futures contracts for wheat converge as time gets closer to the delivery date, so in order to make money on the hedge, the farmer must close out his position earlier than then. On the chance that prices decrease in the future, the farmer will make a profit on his short position in the futures market which offsets any decrease in revenues from the spot market for wheat. On the other hand, if prices increase, the farmer will generate a loss on the futures market which is offset by an increase in revenues on the spot market for wheat. Instead of agreeing to sell his wheat to one person on a set date, the farmer will just buy and sell futures on an exchange and then sell his wheat wherever he wants once he harvests it.
Hedging a stock price
A common hedging technique used in the financial industry is the
long/short equity
Long/short equity is an investment strategy generally associated with hedge funds. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. This is different from the ri ...
technique.
A
stock trader
A stock trader or equity trader or share trader, also called a stock investor, is a person or company involved in trading equity securities and attempting to profit from the purchase and sale of those securities. Stock traders may be an invest ...
believes that the
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
price of Company A will rise over the next month, due to the company's new and efficient method of producing
widgets. They want to buy Company A shares to
profit
Profit may refer to:
Business and law
* Profit (accounting), the difference between the purchase price and the costs of bringing to market
* Profit (economics), normal profit and economic profit
* Profit (real property), a nonpossessory intere ...
from their expected price increase, as they believe that shares are currently underpriced. But Company A is part of a highly volatile widget industry. So there is a
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
of a future event that affects stock prices across the whole industry, including the stock of Company A along with all other companies.
Since the trader is interested in the specific company, rather than the entire industry, they want to ''hedge out'' the industry-related risk by
short selling
In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. This is the opposite of a more conventional "long" position, where the investor will profit if the value of the a ...
an equal value of shares from Company A's direct, yet weaker
competitor
Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, indivi ...
, Company B.
The first day the trader's
portfolio
Portfolio may refer to:
Objects
* Portfolio (briefcase), a type of briefcase
Collections
* Portfolio (finance), a collection of assets held by an institution or a private individual
* Artist's portfolio, a sample of an artist's work or a ...
is:
*
Long
Long may refer to:
Measurement
* Long, characteristic of something of great duration
* Long, characteristic of something of great length
* Longitude (abbreviation: long.), a geographic coordinate
* Longa (music), note value in early music mensur ...
1,000 shares of Company A at $1 each
*
Short
Short may refer to:
Places
* Short (crater), a lunar impact crater on the near side of the Moon
* Short, Mississippi, an unincorporated community
* Short, Oklahoma, a census-designated place
People
* Short (surname)
* List of people known as ...
500 shares of Company B at $2 each
The trader has sold short the same value of shares (the value, number of shares × price, is $1000 in both cases).
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
In finance, a put or put option is a derivative instrument in financial markets that gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the ''underlying''), at a specified price (the ''strike''), by (or at) a s ...
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. But the hedge – the short sale of Company B – nets a profit of $25 during a dramatic market collapse.
Stock/futures hedging
The introduction of
stock market index future
In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index. The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for ...
s has provided a second means of hedging risk on a single stock by selling short the market, as opposed to another single or selection of stocks. Futures are generally highly
fungible
In economics, fungibility is the property of a good or a commodity whose individual units are essentially interchangeable, and each of whose parts is indistinguishable from any other part. Fungible tokens can be exchanged or replaced; for exam ...
and cover a wide variety of potential investments, which makes them easier to use than trying to find another stock which somehow represents the opposite of a selected investment. Futures hedging is widely used as part of the traditional long/short play.
Hedging employee stock options
Employee stock options
Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.
Employee stock options are commonly viewed as an internal agreement prov ...
(ESOs) are securities issued by the company mainly to its own executives and employees. These securities are more volatile than stocks. An efficient way to lower the ESO risk is to sell exchange traded calls and, to a lesser degree, to buy puts. Companies discourage hedging the ESOs but there is no prohibition against it.
Hedging fuel consumption
Airline
An airline is a company that provides civil aviation, air transport services for traveling passengers and freight. Airlines use aircraft to supply these services and may form partnerships or Airline alliance, alliances with other airlines for ...
s use
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s and
derivatives
The derivative of a function is the rate of change of the function's output relative to its input value.
Derivative may also refer to:
In mathematics and economics
* Brzozowski derivative in the theory of formal languages
* Formal derivative, an ...
to hedge their exposure to the price of
jet fuel
Jet fuel or aviation turbine fuel (ATF, also abbreviated avtur) is a type of aviation fuel designed for use in aircraft powered by gas-turbine engines. It is colorless to straw-colored in appearance. The most commonly used fuels for commercial a ...
. 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
Petroleum, also known as crude oil, or simply oil, is a naturally occurring yellowish-black liquid mixture of mainly hydrocarbons, and is found in geological formations. The name ''petroleum'' covers both naturally occurring unprocessed crude ...
futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions),
Southwest Airlines
Southwest Airlines Co., typically referred to as Southwest, is one of the major airlines of the United States and the world's largest low-cost carrier. It is headquartered in Dallas, Texas, and has scheduled service to 121 destinations in the U ...
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
The 2003 invasion of Iraq was a United States-led invasion of the Republic of Iraq and the first stage of the Iraq War. The invasion phase began on 19 March 2003 (air) and 20 March 2003 (ground) and lasted just over one month, including 26 ...
and
Hurricane Katrina
Hurricane Katrina was a destructive Category 5 Atlantic hurricane that caused over 1,800 fatalities and $125 billion in damage in late August 2005, especially in the city of New Orleans and the surrounding areas. It was at the time the cost ...
.
Hedging emotions
As an emotion regulation strategy, people can bet against a desired outcome. A New England Patriots fan, for example, could bet their opponents to win to reduce the negative emotions felt if the team loses a game. Some
scientific wager A scientific wager is a wager whose outcome is settled by scientific method. They typically consist of an offer to pay a certain sum of money on the scientific proof or disproof of some currently-uncertain statement. Some wagers have specific date r ...
s, such as
Hawking's 1974 "insurance policy" bet, fall into this category.
People typically do not bet against desired outcomes that are important to their identity, due to negative signal about their identity that making such a gamble entails. Betting against your team or political candidate, for example, may signal to you that you are not as committed to them as you thought you were.
Types of hedging
Hedging can be used in many different ways including
foreign exchange trading
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all asp ...
. The stock example above is a "classic" sort of hedge, known in the industry as a
pairs trade
A pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence ...
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 include:
* Forward exchange contract for currencies
* Commodity future contracts for hedging physical positions
* Currency future contracts
* Money Market Operations for currencies
* Forward Exchange Contract for interest
* Money Market Operations for interest
* Future contracts for interest
* Covered Calls on equities
* Short Straddles on equities or indexes
* Bets on elections or sporting events
Hedging strategies
![Hou710 HedgeCorridor](https://upload.wikimedia.org/wikipedia/commons/9/91/Hou710_HedgeCorridor.svg)
A hedging strategy usually refers to the general
risk management policy of a
financially and
physically trading
firm
A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal person, legal or a mixture of both, with a specific objective. Company members share a common p ...
how to minimize their risks. As the term hedging indicates, this risk mitigation is usually done by using
financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s, but a hedging strategy as used by
commodity traders like large energy companies, is usually referring to a business model (including both financial ''and'' physical deals).
In order to show the difference between these strategies, consider the fictional company ''BlackIsGreen Ltd'' trading
coal
Coal is a combustible black or brownish-black sedimentary rock, formed as rock strata called coal seams. Coal is mostly carbon with variable amounts of other elements, chiefly hydrogen, sulfur, oxygen, and nitrogen.
Coal is formed when dea ...
by buying this
commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a comm ...
at the
wholesale
Wholesaling or distributing is the sale of goods or merchandise to retailers; to industrial, commercial, institutional or other professional business users; or to other wholesalers (wholesale businesses) and related subordinated services. In ...
market and selling it to households mostly in winter.
Back-to-back hedging
Back-to-back (B2B) is a strategy where any open position is immediately closed, e.g. by buying the respective
commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a comm ...
on the spot market.
This technique is often applied in the
commodity market
A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investin ...
when the customers’ price is directly calculable from visible
forward
Forward is a relative direction, the opposite of backward.
Forward may also refer to:
People
* Forward (surname)
Sports
* Forward (association football)
* Forward (basketball), including:
** Point forward
** Power forward (basketball)
** Sm ...
energy prices at the point of customer sign-up.
If ''BlackIsGreen'' decides to have a B2B-strategy, they would buy the exact amount of coal at the very moment when the household customer comes into their shop and signs the contract. This strategy minimizes many
commodity risk
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise ...
s, but has the drawback that it has a large
volume
Volume is a measure of occupied three-dimensional space. It is often quantified numerically using SI derived units (such as the cubic metre and litre) or by various imperial or US customary units (such as the gallon, quart, cubic inch). The de ...
and
liquidity risk
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Types
Market liquidity – An asset cannot be so ...
, as ''BlackIsGreen'' does not know whether it can find enough coal on the
wholesale
Wholesaling or distributing is the sale of goods or merchandise to retailers; to industrial, commercial, institutional or other professional business users; or to other wholesalers (wholesale businesses) and related subordinated services. In ...
market to fulfill the need of the households.
Tracker hedging
Tracker hedging is a pre-purchase approach, where the open position is decreased the closer the
maturity date
Maturity or immaturity may refer to:
* Adulthood or age of majority
* Maturity model
** Capability Maturity Model, in software engineering, a model representing the degree of formality and optimization of processes in an organization
* Development ...
comes.
If ''BlackIsGreen'' knows that most of the consumers demand coal in winter to heat their house, a strategy driven by a tracker would now mean that ''BlackIsGreen'' buys e.g. half of the expected coal volume in summer, another quarter in autumn and the remaining volume in winter. The closer the winter comes, the better are the weather forecasts and therefore the estimate, how much coal will be demanded by the households in the coming winter.
Retail customers’ price will be influenced by long-term wholesale price trends. A certain ''hedging corridor'' around the pre-defined tracker-curve is allowed and fraction of the open positions decreases as the
maturity date
Maturity or immaturity may refer to:
* Adulthood or age of majority
* Maturity model
** Capability Maturity Model, in software engineering, a model representing the degree of formality and optimization of processes in an organization
* Development ...
comes closer.
Delta hedging
Delta-hedging mitigates the
financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial ...
of an
option by hedging against price changes in its
underlying
In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be use ...
. It is so called as
Delta
Delta commonly refers to:
* Delta (letter) (Δ or δ), a letter of the Greek alphabet
* River delta, at a river mouth
* D (NATO phonetic alphabet: "Delta")
* Delta Air Lines, US
* Delta variant of SARS-CoV-2 that causes COVID-19
Delta may also re ...
is the
first derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. F ...
of the option's value with respect to the underlying
instrument's price. This is performed in practice by buying a
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. F ...
with an inverse price movement. It is also a type of
market neutral An investment strategy or portfolio is considered market-neutral if it seeks to avoid some form of market risk entirely, typically by hedging. To evaluate market-neutrality requires specifying the risk to avoid. For example, convertible arbitrage a ...
strategy.
Only if ''BlackIsGreen'' chooses to perform ''delta-hedging'' as strategy, actual
financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s come into play for hedging (in the usual, stricter meaning).
Risk reversal
Risk reversal
In finance, risk reversal (also known as a ''conversion'' when an investment strategy) can refer to a measure of the volatility skew or to a trading strategy.
Risk reversal investment strategy
A risk-reversal is an option position that consist ...
means simultaneously buying a
call option
In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an ...
and selling a
put option
In finance, a put or put option is a derivative instrument in financial markets that gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the ''underlying''), at a specified price (the ''strike''), by (or at) a s ...
. This has the effect of simulating being long on a stock or commodity position.
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such as the
married put
A protective option or married option is a financial transaction in which the holder of securities buys a type of financial options contract known as a "call" or a " put" against stock that they own or are shorting. The buyer of a protective opti ...
. 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
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
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
financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial ...
that can be protected against with a hedge. Those types of risks include:
*
Commodity risk
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise ...
: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.
*
Credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
: the risk that money owing will not be paid by an
obligor
A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tran ...
. 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
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee.See "Time Value", "Discount", "Discount Yield", "Compound Interest", "Efficient ...
rate.
*
Currency risk
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
(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
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinc ...
: the risk that the relative value of an interest-bearing liability, such as a loan or a
bond
Bond or bonds may refer to:
Common meanings
* Bond (finance), a type of debt security
* Bail bond, a commercial third-party guarantor of surety bonds in the United States
* Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
, will worsen due to an
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
increase. Interest rate risks can be hedged using fixed-income instruments or
interest rate swaps
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...
.
*
Equity risk
Equity risk is "the financial risk involved in holding equity in a particular investment." Equity risk often refers to equity in companies through the purchase of stocks, and does not commonly refer to the risk in paying into real estate or buildi ...
: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.
*
Volatility risk
Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlying is a major influencer of ...
: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.
*
Volume risk Volume risk is a commodity risk which refers to the fact that a player in the commodity market has uncertain quantities of consumption or sourcing, i.e. production of the respective commodity. Examples of other circumstances which can cause large de ...
is 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 (the index in which Vodafone trades).
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.
Futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s and
forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of deriva ...
s are means of hedging against the risk of adverse market movements. These originally developed out of
commodity market
A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investin ...
s 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
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
In a broad sense, an electricity market is a system that facilitates the exchange of electricity-related goods and services. During more than a century of evolution of the electric power industry, the economics of the electricity markets had un ...
pool. If the producer and the retailer agree to a
strike price
In finance, the strike price (or exercise price) of an option is a fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. The strike price may be set b ...
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
In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a thr ...
" because without the hedge they would have received the benefit of the pool price.
Related concepts
*
Forwards: A contract specifying future delivery of an amount of an item, at a price decided now. The delivery is obligatory, not optional.
*
Forward rate agreement In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).
General description
A forward rate agreement's (FRA's) effective descript ...
(FRA): A contract specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract.
*
Option (finance)
In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date ...
: similar to a forward contract, but optional.
**
Call option
In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an ...
: A contract that gives the owner the right, but not the obligation, to buy an item in the future, at a price decided now.
**
Put option
In finance, a put or put option is a derivative instrument in financial markets that gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the ''underlying''), at a specified price (the ''strike''), by (or at) a s ...
: A contract that gives the owner the right, but not the obligation, to sell an item in the future, at a price decided now.
*
Non-deliverable forward
In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is ...
s (NDF): A strictly risk-transfer financial product similar to a
forward rate agreement In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).
General description
A forward rate agreement's (FRA's) effective descript ...
, 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
In macroeconomics, hard currency, safe-haven currency, or strong currency is any globally traded currency that serves as a reliable and stable store of value. Factors contributing to a currency's ''hard'' status might include the stability and ...
, 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
Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measure ...
.
*
Interest rate parity
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportuniti ...
and
Covered interest arbitrage Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to ''cover'' (eliminate exposure to) foreign exchange risk, exchange rate ...
: 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.
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Hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as sho ...
: A fund which may engage in hedged transactions or hedged investment strategies.
See also
* Accounting specific:
**
IAS 39
IAS 39: Financial Instruments: Recognition and Measurement was an international accounting standard which outlined the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell n ...
**
FASB 133
Launched prior to the millennium, (and subsequently amended) FAS 133 ''Accounting for Derivative Instruments and Hedging Activities'' provided an "integrated accounting framework for derivative instruments and hedging activities."
FAS 133 Overvi ...
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Cash flow hedge
{{finance-stub
A cash flow hedge is a hedge of the exposure to the variability of cash flow that
# is attributable to a particular risk associated with a recognized asset or liability. Such as all or some future interest payments on variable rat ...
**
Hedge accounting
Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account.
There are two types of hedge recognized. For a fair value hedge, the offset ...
**
Hedge relationship (finance) In Accounting, a Hedge relationship refers to the treatment of an insurance contract for risk mitigation on an underlying asset, and the set of tests for the valuation of this insurer/insuree contract.
More specifically, the accounting term "Hed ...
References
External links
Understanding Derivatives: Markets and InfrastructureFederal Reserve Bank of Chicago, Financial Markets Group
Basic Fixed Income Derivative Hedging Article on Financial-edu.comHedging Corporate Bond Issuance with Rate Locks article on Financial-edu.com
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Derivatives (finance)
Market risk