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, many types of over-the-counter and derivative products, and futures contracts.

Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate 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.

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.

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.

Futures contracts are another way our farmer can hedge his risk without a few of the risks that forward contracts have. Futures 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 clearing houses. Clearing houses ensure that every contract is honored and they take the opposite side of every contract. Futures 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 futures contracts. Futures contracts also differ from forward contracts in that delivery never happens. The exchanges and clearing houses 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.

  • 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

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 risks, but has the drawback that it has a large volume and liquidity risk, as BlackIsGreen does not know whether it can find enough coal on the wholesale 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 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 comes closer.

Delta hedging

Delta-hedging mitigates the financial risk of an option by hedging against price changes in its underlying. It is so called as Delta is the first derivative of the option's value with respect to the underlying instrument's price. This is performed in practice by buying a derivative with an inverse price movement. It is also a type of market neutral strategy.

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 married 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 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 various types of financial risk that can be protected against with a hedge. Those include:

  • Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products. Corporates commodity-derivatives where available, or, if warranted, purchase a bespoke OTC hedge.
  • Credit risk: 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, an early market developed between banks and traders that involved selling obligations at a discounted rate. The contemporary practice in commerce settings is to purchase trade credit insurance; in an (investment) banking context, these risks can be hedged through credit derivatives. In the latter, analysts use CS01 re sensitivity, and models such as Jarrow–Turnbull and Merton / KMV to estimate the (risk neutral) probability of default, and/or (portfolio-wide) will use a transition matrix of Bond credit ratings to estimate the (actuarial) probability and impact of a "credit migration". 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 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 for further discussion.
  • Interest rate risk: the risk that the value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase (see ). Interest rate risks can be hedged using Interest rate derivatives such as interest rate swaps; sensitivities here are measured using duration and convexity for bonds, and DV01 and key rate durations generally. At the portfolio level, cash-flow risks are typically managed via immunization or cashflow matching, while valuation-risk is hedged through bond index futures or options
  • Volatility risk: the risk of a change in the volatility of a risk factor, negatively impacting the price of a portfolio or instrument. This risk particularly applies to derivative instruments, where the volatility of the underlying is a major influence on prices. It is also relevant to portfolios of basic assets, and to foreign currency trading. This risk can be managed is the concern that sales volumes will materially deviate from planned or budgeted amounts. Particularly in the context of commodities, the concern extends also to uncertainty re production. The management here may include formally modeling demand and responding dynamically (if not preemptively) to the market; for production uncertainty, an approach often taken is to diversify spatially.

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  • 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

References

  • 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