Hedger redirects here. For the surname, seeHedger (surname).
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Ahedgeis 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, includingstocksexchange-traded fundsinsuranceforward contractsswapsoptions, gambles,1many types ofover-the-counterandderivativeproducts, andfutures contracts.
Publicfutures marketswere established in the 19th century2to allow transparent, standardized, and efficient hedging of agriculturalcommodityprices; they have since expanded to includefutures contractsfor hedging the values ofenergyprecious metalsforeign currency, andinterest ratefluctuations.
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 Englishhecg, 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 ofinsure oneself against loss,as in a bet, is from the 1670s.3
A typical hedger might be a commercial farmer. The market values ofwheatand other crops fluctuate constantly assupply and demandfor 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, said farmer may use different financial transactions to reduce, or hedge, their risk. One such transaction is the use offorwardcontracts. 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.4
Futurecontracts 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 throughclearinghouses. 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.4
A common hedging technique used in the financial industry is thelong/short equitytechnique.
Astock traderbelieves that thestockprice of Company A will rise over the next month, due to the companys new and efficient method of producingwidgets. He wants to buy Company A shares toprofitfrom their expected price increase, as he believes that shares are currently underpriced. But Company A is part of a highly volatile widget industry. So there is ariskof 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, he wants tohedge outthe industry-related risk byshort sellingan equal value of shares from Company As direct, yet weakercompetitor, Company B.
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 As stock price (for example aput optionon Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put options 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:
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 Bs shares to buy Company As shares as well). But the hedge the short sale of Company B net a profit of $25 during a dramatic market collapse.
The introduction ofstock market index futureshas 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 highlyfungibleand 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.
Employee stock options(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,clarification neededto buy puts. Companies discourage hedging the ESOs but there is no prohibition against it.
Airlinesusefutures contractsandderivativesto hedge their exposure to the price ofjet fuel. 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 usingcrude oilfutures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions),Southwest Airlineswas 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 the2003 Iraq warandHurricane Katrina.
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. 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 can be used in many different ways includingforeign exchange trading. The stock example above is a classic sort of hedge, known in the industry as apairs tradedue 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.
Ahedging strategyusually refers to the generalrisk managementpolicy of afinanciallyandphysicallytradingfirmhow to minimize their risks. As the term hedging indicates, this risk mitigation is usually done by usingfinancial instruments, but a hedging strategy as used bycommodity traderslike large energy companies, is usually referring to a business model (including both financialandphysical deals).
In order to show the difference between these strategies, let us consider the fictional companyBlackIsGreen Ltdtradingcoalby buying thiscommodityat thewholesalemarket and selling it to households mostly in winter.
Back-to-back(B2B) is a strategy where any open position is immediately closed, e.g. by buying the respectivecommodityon the spot market. This technique is often applied in thecommodity marketwhen the customers price is directly calculable from visibleforwardenergy prices at the point of customer sign-up.6
IfBlackIsGreendecides 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 manycommodity risks, but has the drawback that it has a largevolumeandliquidity risk, asBlackIsGreendoes not know how whether it can find enough coal on thewholesalemarket to fulfill the need of the households.
Tracker hedgingis a pre-purchase approach, where the open position is decreased the closer thematurity datecomes.
IfBlackIsGreenknows that most of the consumers demand coal in winter to heat their house. A strategy driven by a tracker would now mean thatBlackIsGreenbuys 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 certainhedging corridoraround the pre-defined tracker-curve is allowed and fraction of the open positions decreases as thematurity datecomes closer.
Delta-hedgingmitigates thefinancial riskof anoptionby hedging against price changes in itsunderlying. It is called like that asDeltais thefirst derivativeof the options value with respect to the underlyinginstruments price. This is performed in practice by buying aderivativewith an inverse price movement. It is also a type ofmarket neutralstrategy.
Only ifBlackIsGreenchooses to performdelta-hedgingas strategy, actualfinancial instrumentscome into play for hedging (in the usual, stricter meaning).
Risk reversalmeans simultaneously buying acall optionand selling aput option. This has the effect of simulating being long on a stock or commodity position.
Many hedges do not involve exotic financial instruments or derivatives such as themarried 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 ofinsuranceto protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.
There are varying types offinancial riskthat 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.
Credit risk: the risk that money owing will not be paid by anobligor. 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 adiscountedrate.
Currency risk(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: the risk that the relative value of an interest-bearing liability, such as a loan or abond, will worsen due to aninterest rateincrease. Interest rate risks can be hedged using fixed-income instruments orinterest rate swaps.
Equity risk: the risk that ones investments will depreciate because of stock market dynamics causing one to lose money.
Volatility risk: is the threat that an exchange rate movement poses to an investors portfolio in a foreign currency.
Volume riskis the risk that a customer demands more or less of a product than expected.
Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking againstsystematic market risk, futures are shorted when equity is purchased, or long futures when stock isshorted.
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 contractsandforward contractsare means of hedging against the risk of adverse market movements. These originally developed out ofcommodity marketsin the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.
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 hedgingis 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.
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 anelectricity marketpool. If the producer and the retailer agree to astrike priceof $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 isout of the moneybecause without the hedge they would have received the benefit of the pool price.
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 aForward 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 thathard 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; its just that the supply of insured currency is restricted and controlled by government. Seecapital control.
Interest rate parityandCovered 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.
Accountant specific:IAS 39FASB 133Cash flow hedgeHedge accounting
Morewedge, Carey K.; Tang, Simone; Larrick, Richard P. (2016-10-12).Betting Your Favorite to Win: Costly Reluctance to Hedge Desired Outcomes.
A survey of financial centres: Capitals of capital. The Economist. 1998-05-07
Online Etymology Dictionary definition of hedge.
. 978-1-61549-777-5: Great River Technologies. pp.349359.
Understanding Derivatives: Markets and Infrastructure – Federal Reserve Bank of Chicago.
Energiedienstleistungen Strom und Gas fr Energiewirtschaft und energieintensive Industrieunternehmen
(5 ed.). John Wiley and Sons. p.287.ISBN978-0-470-47961-2.
Understanding Derivatives: Markets and InfrastructureFederal Reserve Bank of Chicago, Financial Markets Group
Basic Fixed Income Derivative Hedging Article on
Hedging Corporate Bond Issuance with Rate Locks article on m
Commodity risk(e.g.Volume riskBasis riskShape riskHolding period riskPrice area risk)
Value-at-Risk (VaR)and extensionsProfit at riskMargin at riskLiquidity at risk
Capital asset pricing modelalphabetasecurity characteristic line)
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