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. 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 then 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 hedge. 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, such as 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. Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency.
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[edit] Example hedge
A stock trader believes that the stock price of FOO, Inc., will rise over the next month, due to this company's new and efficient method of producing 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 industry risk by short selling an equal value (number of shares x price) of the shares of FOO's direct competitor, BAR. If the trader were 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 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 => $450 loss
Value of short position:
- Day 1 — $1000
- Day 2 — $1050
- Day 3 — $525 => $475 profit
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.
[edit] 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 diverge.
[edit] Natural hedges
Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, (for example) 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 could choose 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 local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local 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 face 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.
[edit] 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. For instance, consider 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 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 "out of the money" because without the hedge they would have received the benefit of the pool price.
[edit] 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.
[edit] Hedging insurance risk
One of the oldest means of hedging against risk is the purchase of protection against accidental property damage or loss, personal injury, or loss of life. See Insurance.
[edit] 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 involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.
More recent forms of hedging have become available in the credit derivatives market.
[edit] Hedging Currency Risk (aka Foreign Exchange Risk, or FX Risk)
Currency hedging is used both by financial investors to parse out the risks they encounter when investing overseas, as well as by non-financial actors in the global economy for whom multi-currency activities is a necessary evil rather than a desired state of exposure.
For example, cost of labor variables dictate that much of the simple commoditized manufacturing in the global economy today goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of never having done business in foreign countries, so many businesses are jumping into the fray and becoming part of the globalization trend of moving manufacturing operations overseas. The benefits of doing this however, come with numerous risks that were never a problem when manufacturing was done at home--among them currency risk.
If your cost of manufacturing goods in another country is denominated in a currency other than the one that you sell the finished goods in, there is the risk that the currency "volatility" alone may destroy the margin between what you pay to produce your product, and what you collect when you sell it (note you may be selling your product in a foreign country too, so you can hedge against the currency risk on this side as well!). So when you convert all costs on the production side, and all sales receipts from the retail side, back into your home currency, you may be alarmed to find that your profits have diminished significantly, or disappeared altogther. That's currency risk-- it is germane to doing business globally, but entirely independent of your specific business or products. Currency hedging then, is the insurance you can purchase to limit the impact this unpredictable risk has on your business, the same way Fire or Hurricane insurance protects your physical premises from unexpected events beyond your control.
Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity. The currencies beyond the Major 8 can most reliably be identified by checking to see which are included within the "Continuous-Linked Settlement Bank" "(CLS Bank)", which handles a growing percentage of the globe's daily settlement volume between currencies.
Currency hedging, like many other forms of financial hedging, can be done in two primary ways, with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).
The financial investor application may be that a hedge fund (let's say, based in New York) finds a great company to invest in, but doesn't want to necessarily be investing in the currency of the country this company resides in (let's say, Brazil for example). So, the hedge fund can separate out the credit risk (eg the Company, which it wants to take a position in), from the currency risk (eg the Brazilian Real, which it doesn't want to take a position in) by "hedging" out the currency risk. In effect, this means that the investment the hedge fund makes into the company is effectively a USD investment, in Brazil. Hedging product allows the investor to transfer the currency risk to someone else who does want to take a position in the currency. The New York based hedge fund has to pay this other investor to take on the currency exposure, the same way you pay any insurance company to provide insurance against an unknown outcome. The "gamble" the insurance provider takes is that the ultimate outcome during the period insured will not exceed the amount the buyer paid; the insurance provider may, however, be hedging their own risk on a similar (mirror image) transaction.
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The neutrality of this section is disputed. Please see the discussion on the talk page. |
In this way, the global economy becomes more efficient, because two investors are able to take positions they both want. Let's take a look at what would happen if the hedging product weren't available: The hedge fund in New York isn't able to strip out the currency risk from the credit risk it wants to take, therefore it decides not to make the investment in the Brazilian company because it is too risky for their appetite. The Brazilian company runs out of operating capital because it can't get credit locally, and therefore the company has to shut down or cut back. Brazil loses both jobs, as well as economic output. Brazil's GDP suffers, and the investment returns of the hedge fund may suffer as well. For all of the complaining about hedging (not necessarily hedge funds) ruining the global economy, this mostly stems from the lack of understanding by Politicians and others of what function hedging product actually serves. In the same way that Life Insurance revolutionized productivity following the Great Depression because it allowed people (eg high-rise construction workers) to take incrementally more risk thereby earning a greater income for their efforts (eg danger-pay) knowing that their families would be taken care of should something happen to them (eg if they fall off the skyscraper!), hedging allows actors in the global economy to take incremental risks, which increases productivity, expands global economic output, which then in general raises all boats.
[edit] Some related concepts to investigate:
- Forwards
- A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
- Forward Rate Agreement
- A contract agreement specifying an interest rate amount to be settled, at an pre-determined interest rate on the date of the contract. This is also known as FRAs.
- Currency option
- A contract that gives the owner the right but not the obligation to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
- Non-deliverable forward (NDF)
- A strictly risk-transfer financial product similar to a Forward Rate Agreement, but only used where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. NDFs are, as the name suggests, not delivered, but rather, these are 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.
- Currency swap
- FX swap
- Interest rate swap
- Basis swap
- Quanto swap
- Diff swap
- 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 gives you 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 you had invested in the same opportunity in the original currency.
- Distributed Funds Transfer Hedge (DFT-hedge)
[edit] 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 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures.
[edit] Futures hedging
If you primarily trade in futures, you hedge your 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. So if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.
[edit] See also
- Arbitrage
- Hedge fund
- Immunization (finance)
- List of finance topics
- Spread
- Risk in Finance (category)
[edit] External links
- Guide to Hedging Interest Rate Risk
- Hedging With Beta - Article on hedging equities with a relative beta.
- Weather hedging
- Hedging in Currency Markets
- Hedging
