Hedge (finance)
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. 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. 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 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.
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 short selling an equal value of shares from Company A's direct, yet weaker competitor, Company B.
The first day the trader's portfolio is:
The trader has sold short the same value of shares.
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price, 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
Value of long position :
- Day 1: $1,000
- Day 2: $1,100
- Day 3: $550 => = $450 loss
- Day 1: −$1,000
- Day 2: −$1,050
- Day 3: −$525 => = $475 profit
Stock/futures hedging
The introduction of stock market index futures has 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 highly fungible and 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.Hedging employee stock options
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, to buy puts. Companies discourage hedging the ESOs but there is no prohibition against it.Hedging fuel consumption
s use futures contracts and derivatives to hedge their exposure to the price of jet 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 using crude oil futures contracts to hedge their fuel requirements, Southwest Airlines was 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 the 2003 Iraq war and Hurricane Katrina.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 negative emotions felt if the team loses a game. Some scientific wagers, such as Hawking's 1974 "insurance policy" bet, fall into this category.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.