Hedge (finance)
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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 instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles,[1] many types of over-the-counter and derivative products, and futures contracts.
Public
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.[3]
Hedge-investment duality
Optimal hedging and optimal investments are intimately connected. It can be shown that one person's optimal investment is another's optimal hedge (and vice versa). This follows from a geometric structure formed by probabilistic representations of market views and risk scenarios. In practice, the hedge-investment duality is related to the widely used notion of risk recycling.
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 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.[4]
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 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.[5]
Hedging a stock price
A common hedging technique used in the financial industry is the long/short equity technique.
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. They want to buy Company A shares to profit 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 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
The first day the trader's portfolio is:
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 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
Hedging employee stock options
Hedging fuel consumption
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
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.[1]
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 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
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 "
Types of hedging
Hedging can be used in many different ways including
Examples of hedging include:[7]
- 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[1]
Hedging strategies
A hedging strategy usually refers to the general
In order to show the difference between these strategies, consider the fictional company BlackIsGreen Ltd trading
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 on the spot market. This technique is often applied in the commodity market when the customers’ price is directly calculable from visible forward energy prices at the point of customer sign-up.[8]
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
Tracker hedging
Tracker hedging is a pre-purchase approach, where the open position is decreased the closer the maturity date 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
Delta hedging
Delta-hedging mitigates the
Only if BlackIsGreen chooses to perform delta-hedging as strategy, actual financial instruments come into play for hedging (in the usual, stricter meaning).
Risk reversal
Risk reversal means simultaneously buying a call option and selling a put option. 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
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 financial 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.[9][10][11] Corporates [10] exposed on the "procurement side" of the value chain, require protection against rising commodity prices, where these cannot be "passed on to the customer"; on the sales side, corporates look towards hedging against a decline in price. Both may hedge using [12] commodity-derivatives where available, or, if warranted, purchase a bespoke OTC hedge.
- KMV to estimate the probability of default, and/or (portfolio-wide) will use a transition matrix of Bond credit ratings [13] to estimate the probability and impact of a "credit migration".[14] See Fixed income analysis.
- Currency risk: the risk that a financial instrument or business transaction will be affected unfavorably by a change in exchange rates. Foreign exchange risk hedging[15][16] is used both by 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. See also Currency analytics.
- Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. Additional to diversification – the fundamental risk mitigant here – investment managers will apply various risk management techniques to their portfolios as appropriate: these may relate to the portfolio as a whole or to individual stocks as above; see Financial risk management § Investment management for further discussion.
- bond indexfutures or options
- futures contracts.
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 (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): similar to a forward contract, but optional.
- Call option: 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: 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 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)
- Financial risk management
- Fixed bill
- Foreign exchange hedge
- Fuel price risk management
- Immunization (finance)
- Inflation hedge
- List of finance topics
- Option (finance)
- Spread
- Superhedging price
- Texas hedge
- Accounting specific:
- IAS 39
- FASB 133
- Cash flow hedge
- Hedge accounting
- Hedge relationship (finance)
References
- ^ ISSN 0025-1909.
- ^ "A survey of financial centres: Capitals of capital". The Economist. 1998-05-07. Retrieved 2011-10-20.
- ^ "Online Etymology Dictionary definition of hedge". Retrieved 2023-01-10.
- ^ Commodities, Ashland (2023-04-08). "Grain Risk Management - Are You Hedging or Speculating". Ashland Commodities. Retrieved 2023-08-22.
- ^ a b Oltheten, Elisabeth; Waspi, Kevin G. (2012). Financial Markets: A Practicum. 978-1-61549-777-5: Great River Technologies. pp. 349–359.
{{cite book}}
: CS1 maint: location (link) - ^ Commodities, Ashland (2023-01-10). "Fundamentals of Grain Hedging - Futures". Ashland Commodities. Retrieved 2023-08-22.
- ^ "Understanding Derivatives: Markets and Infrastructure - Federal Reserve Bank of Chicago". chicagofed.org. Retrieved 29 March 2018.
- ^ "Energiedienstleistungen Strom und Gas für Energiewirtschaft und energieintensive Industrieunternehmen" (PDF). citiworks AG. Archived from the original (PDF) on 22 December 2015. Retrieved 15 December 2015.
- ISBN 978-0-470-47961-2.
- ^ a b Deloitte / MCX (2018). Commodity price risk management
- ^ CPA Australia (2012). A guide to managing commodity risk
- Bloomberg.com (2022). 5 things new commodities hedgers need to know
- ^ Paul Glasserman (2000). Probability Models of Credit Risk
- ^ Staff (2021). How Credit Rating Risk Affects Corporate Bonds, Investopedia
- ^ Association of Chartered Certified Accountants (N.D.). "Foreign currency risk and its management".
- ^ CPA Australia (2009). A guide to managing foreign exchange risk
- ^ Association of Chartered Certified Accountants (N.D.). "Interest rate risk management"
- ^ CPA Australia (2008). Understanding and Managing Interest Rate Risk
- ^ a b Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). "Hedging volatility risk". Journal of Banking & Finance 30 (2006) 811–821
External links
- Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group
- Basic Fixed Income Derivative Hedging Article on Financial-edu.com
- Hedging Corporate Bond Issuance with Rate Locks article on Financial-edu.com