Hedge (finance)
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In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. The term comes from a gambling saying "hedging your bets." Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is just now making), and combine this with a short sale of a related security or securities. Thus the hedger doesn't care whether the market as a whole goes up or down in value, only whether the under-priced security appreciates relative to the market. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," [1] where the basis is the difference between the security's theoretical value and its actual value (or between spot and futures prices in Working's time).
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, e.g. the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. For example someone who has a shop, takes care of the risk of competition, of poor or unpopular products, and so on, as natural risks. The risk of their inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract.
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Example hedge
A stock trader believes that the stock price of FOO, Inc. will rise over the next month, based on his information about consumer preferences for widgets. He wants to buy FOO shares to profit from their expected price increase. But FOO is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the FOO 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 risk by short selling an equal amount of the shares of FOO's direct competitor, BAR. If the trader was able to short sell an asset whose price had a mathematically defined relation with FOO's stock price (for example a call option on FOO shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:
(Notice that the trader has sold short the same value of shares).
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:
- Long 1000 shares of FOO at $1.10 each — $100 profit
- Short 500 shares of BAR 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's reduced the profits on the FOO 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 FOO is the better company it suffers less than BAR:
Value of long position:
- Day 1 — $1000
- Day 2 — $1100
- Day 3 — $550
Value of short position:
- Day 1 — $1000
- Day 2 — $1050
- Day 3 — $525
Without the hedge, the trader would have lost $450. But the hedge - the short sale of BAR - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
Types of hedging
The 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. In general, however, all hedge strategies look for a "spread" between market value and theoretical or "true" value, and attempt to extract profits when the values converge.
Contract for Differences
A Contract for Differences (CfD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. An example would be 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 a strike price of, say $50 per MWh, for 1 MWh in a trading period, then if the actual pool price is $70, then the producer get $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. On the other hand the retailer pays the difference to the producer if the pool price is lower than the 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.
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 – the risk, for those who borrow, that interest rates will rise, (or for those who lend, that they fall)
- Equity – the risk, for those whose assets are equity holdings, that the value of the equity falls
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 there has developed a huge global market in products to hedge financial market risk.
Hedging insurance risk
One of the oldest means of hedging against risk is the purchase of protection against accidental loss or damage to property, or injury, loss of life. See Insurance.
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 involved selling obligations at a discounted rate. See for example forfaiting, bill of lading, or discounted bill.
More recent forms of hedging have become available in the credit derivatives market.
Hedging foreign exchange (forex) risk
When an importer or exporter places an order, a contract price is agreed that is enumerated in the currency of one or other party. Exchange rate movements between order and invoice payment can easily cut into margins and even turn a profit into a loss. This is known as "volatility risk". Consequently, the party at risk of adverse movement needs to insure against that possibility and does so by buying a hedging instrument.
Hedging Equity & 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 USD long position in Vodafone you will hedge with a 5000 GBP equivalent short position in the FTSE futures.
Futures Hedging If you primarily trade in futures, you hedge your futures against synthetic futures. A synthetic in this case is a synthetic futures comprising a call and a put potion. Long synthetic futures means long call and short put at the same expiry price. So if you long futures in your trade you can hedge by shorting synthetics.
See also
External links
fr:Couverture de risque it:Hedging ru:Хеджирование sv:Hedgefond