Hedge (nance)

For other uses, see Hedge (disambiguation). a lot of unexpected money, but if the actual price drops
Hedger redirects here. For the surname, see Hedger by harvest time, he is going to lose the invested money.
(surname).
Due to the uncertainty of future supply and demand uc-
tuations, and the price risk imposed on the farmer, said
A hedge is an investment position intended to oset po- farmer may use dierent nancial transactions to reduce,
tential losses or gains that may be incurred by a compan- or hedge, their risk. One such transaction is the use of
ion investment. In simple language, a hedge is used to forward contracts. Forward contracts are mutual agree-
reduce any substantial losses or gains suered by an indi- ments to deliver a certain amount of a commodity at a cer-
vidual or an organization. tain date for a specied price and each contract is unique
A hedge can be constructed from many types of nancial to the buyer and seller. For this example, the farmer
instruments, including stocks, exchange-traded funds, can sell a number of forward contracts equivalent to the
insurance, forward contracts, swaps, options, gambles,[1] amount of wheat he expects to harvest and essentially lock
many types of over-the-counter and derivative products, in the current price of wheat. Once the forward contracts
and futures contracts. expire, the farmer will harvest the wheat and deliver it to
the buyer at the price agreed to in the forward contract.
Public futures markets were established in the 19th Therefore, the farmer has reduced his risks to uctuations
century[2] to allow transparent, standardized, and e- in the market of wheat because he has already guaranteed
cient hedging of agricultural commodity prices; they have a certain number of bushels for a certain price. How-
since expanded to include futures contracts for hedging ever, there are still many risks associated with this type
the values of energy, precious metals, foreign currency, of hedge. For example, if the farmer has a low yield year
and interest rate uctuations. and he harvests less than the amount specied in the for-
ward contracts, he must purchase the bushels elsewhere
in order to ll the contract. This becomes even more of a
1 Etymology problem when the lower yields aect the entire wheat in-
dustry and the price of wheat increases due to supply and
Hedging is the practice of taking a position in one market demand pressures. Also, while the farmer hedged all of
to oset and balance against the risk adopted by assuming the risks of a price decrease away by locking in the price
a position in a contrary or opposing market or investment. with a forward contract, he also gives up the right to the
The word hedge is from Old English hecg, originally any benets of a price increase. Another risk associated with
fence, living or articial. The use of the word as a verb in the forward contract is the risk of default or renegotiation.
the sense of dodge, evade is rst recorded in the 1590s; The forward contract locks in a certain amount and price
that of insure oneself against loss, as in a bet, is from the at a certain future date. Because of that, there is always
1670s.[3] the possibility that the buyer will not pay the amount re-
quired at the end of the contract or that the buyer will try
to renegotiate the contract before it expires.[4]

2 Examples Future contracts 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
2.1 Agricultural commodity price hedging they are more standardized (i.e. each contract is the same
quantity and date for everyone). These contracts trade
A typical hedger might be a commercial farmer. The on exchanges and are guaranteed through clearinghouses.
market values of wheat and other crops uctuate con- Clearinghouses ensure that every contract is honored and
stantly as supply and demand for them vary, with occa- they take the opposite side of every contract. Future con-
sional large moves in either direction. Based on current tracts typically are more liquid than forward contracts and
prices and forecast levels at harvest time, the farmer might move with the market. Because of this, the farmer can
decide that planting wheat is a good idea one season, but minimize the risk he faces in the future through the sell-
the price of wheat might change over time. Once the ing of future contracts. Future contracts also dier from
farmer plants wheat, he is committed to it for an entire forward contracts in that delivery never happens. The ex-
growing season. If the actual price of wheat rises greatly changes and clearinghouses allow the buyer or seller to
between planting and harvest, the farmer stands to make

1
2 2 EXAMPLES

leave the contract early and cash out. So tying back into Long 1,000 shares of Company A at $1.10 each:
the farmer selling his wheat at a future date, he will sell $100 gain
short futures contracts for the amount that he predicts to
harvest to protect against a price decrease. The current Short 500 shares of Company B at $2.10 each: $50
(spot) price of wheat and the price of the futures contracts loss (in a short position, the investor loses money
for wheat converge as time gets closer to the delivery date, when the price goes up)
so in order to make money on the hedge, the farmer must
close out his position earlier than then. On the chance The trader might regret the hedge on day two, since it re-
that prices decrease in the future, the farmer will make duced the prots on the Company A position. But on the
a prot on his short position in the futures market which third day, an unfavorable news story is published about
osets any decrease in revenues from the spot market for the health eects of widgets, and all widgets stocks crash:
wheat. On the other hand, if prices increase, the farmer 50% is wiped o the value of the widgets industry in the
will generate a loss on the futures market which is oset course of a few hours. Nevertheless, since Company A is
by an increase in revenues on the spot market for wheat. the better company, it suers less than Company B:
Instead of agreeing to sell his wheat to one person on a Value of long position (Company A):
set date, the farmer will just buy and sell futures on an
exchange and then sell his wheat wherever he wants once
Day 1: $1,000
he harvests it.[4]
Day 2: $1,100
2.2 Hedging a stock price Day 3: $550 => ($1,000 $550) = $450 loss

A common hedging technique used in the nancials in- Value of short position (Company B):
dustry is the long/short equity technique.
A stock trader believes that the stock price of Company Day 1: $1,000
A will rise over the next month, due to the companys new
and ecient method of producing widgets. He wants to Day 2: $1,050
buy Company A shares to prot from their expected price
Day 3: $525 => ($1,000 $525) = $475 prot
increase, as he believes that shares are currently under-
priced. But Company A is part of a highly volatile widget
industry. So there is a risk of a future event that aects Without the hedge, the trader would have lost $450 (or
stock prices across the whole industry, including the stock $900 if the trader took the $1,000 he has used in short
of Company A along with all other companies. selling Company Bs shares to buy Company As shares
as well). But the hedge the short sale of Company B
Since the trader is interested in the specic company, net a prot of $25 during a dramatic market collapse.
rather than the entire industry, he wants to hedge out the
industry-related risk by short selling an equal value of
shares from Company As direct, yet weaker competitor, 2.3 Stock/futures hedging
Company B.
The rst day the traders portfolio is: The introduction of stock market index futures has pro-
vided a second means of hedging risk on a single stock by
Long 1,000 shares of Company A at $1 each selling short the market, as opposed to another single or
selection of stocks. Futures are generally highly fungible
Short 500 shares of Company B at $2 each and cover a wide variety of potential investments, which
makes them easier to use than trying to nd another stock
The trader has sold short the same value of shares (the which somehow represents the opposite of a selected in-
value, number of shares price, is $1000 in both cases). vestment. Futures hedging is widely used as part of the
If the trader was able to short sell an asset whose price traditional long/short play.
had a mathematically dened relation with Company As
stock price (for example a put option on Company A
2.4 Hedging employee stock options
shares), the trade might be essentially riskless. In this
case, the risk would be limited to the put options pre- Employee stock options (ESOs) are securities issued by
mium. the company mainly to its own executives and employ-
On the second day, a favorable news story about the wid- ees. These securities are more volatile than stocks. An
gets industry is published and the value of all widgets ecient way to lower the ESO risk is to sell exchange
stock goes up. Company A, however, because it is a traded calls and, to a lesser degree, to buy puts. Compa-
stronger company, increases by 10%, while Company B nies discourage hedging the ESOs but there is no prohi-
increases by just 5%: bition against it.
 3

2.5 Hedging fuel consumption Future contracts for interest

Covered Calls on equities
Main article: Fuel hedging
Airlines use futures contracts and derivatives to hedge Short Straddles on equities or indexes
Bets on elections or sporting events[1]

4 Hedging strategies

Target hedge ratio

their exposure to the price of jet fuel. They know that Hedge tracker
they must purchase jet fuel for as long as they want to Hedge corridor
stay in business, and fuel prices are notoriously volatile.
By using crude oil futures contracts to hedge their fuel
Maturity
requirements (and engaging in similar but more complex
derivatives transactions), Southwest Airlines was able to Y-3 Y-2 Y-1 Y
save a large amount of money when buying fuel as com-
pared to rival airlines when fuel prices in the U.S. rose Tracker hedging. The fraction of open positions has to be within
dramatically after the 2003 Iraq war and Hurricane Kat- the (grey-blue) hedging corridor at every instance of time.
rina.
A hedging strategy usually refers to the general risk
management policy of a nancially and physically trad-
2.6 Hedging emotions ing rm how to minimize their risks. As the term hedg-
ing indicates, this risk mitigation is usually done by using
As an emotion regulation strategy, people can bet against nancial instruments, but a hedging strategy as used by
a desired outcome. A New England Patriots fan, for ex- commodity traders like large energy companies, is usu-
ample, could bet their opponents to win to reduce the ally referring to a business model (including both nan-
negative emotions felt if the team loses a game. Peo- cial and physical deals).
ple typically do not bet against desired outcomes that are In order to show the dierence between these strategies,
important to their identity, due to negative signal about let us consider the ctional company BlackIsGreen Ltd
their identity that making such a gamble entails. Bet- trading coal by buying this commodity at the wholesale
ting against your team or political candidate, for example, market and selling it to households mostly in winter.
may signal to you that you are not as committed to them
as you thought you were.[1]
4.1 Back-to-back hedging

3 Types of hedging Back-to-back (B2B) is a strategy where any open posi-

tion is immediately closed, e.g. by buying the respective
commodity on the spot market. This technique is often
Hedging can be used in many dierent ways including applied in the commodity market when the customers
foreign exchange trading. The stock example above is a price is directly calculable from visible forward energy
classic sort of hedge, known in the industry as a pairs prices at the point of customer sign-up.[6]
trade due to the trading on a pair of related securities.
As investors became more sophisticated, along with the If BlackIsGreen decides to have a B2B-strategy, they
mathematical tools used to calculate values (known as would buy the exact amount of coal at the very mo-
models), the types of hedges have increased greatly. ment when the household customer comes into their shop
and signs the contract. This strategy minimizes many
Examples of hedging include:[5] commodity risks, but has the drawback that it has a large
volume and liquidity risk, as BlackIsGreen does not know
Forward exchange contract for currencies how whether it can nd enough coal on the wholesale
market to fulll the need of the households.
Currency future contracts

Money Market Operations for currencies 4.2 Tracker hedging

Forward Exchange Contract for interest
Tracker hedging is a pre-purchase approach, where the
Money Market Operations for interest open position is decreased the closer the maturity date
4 7 HEDGING EQUITY AND EQUITY FUTURES

comes. expect to receive its revenues in U.S. dollars, but faces

If BlackIsGreen knows that most of the consumers de- costs in a dierent currency; it would be applying a nat-
mand coal in winter to heat their house. A strategy driven ural hedge if it agreed to, for example, pay bonuses to
by a tracker would now mean that BlackIsGreen buys e.g. employees in U.S. dollars.
half of the expected coal volume in summer, another One common means of hedging against risk is the pur-
quarter in autumn and the remaining volume in winter. chase of insurance to protect against nancial loss due to
The closer the winter comes, the better are the weather accidental property damage or loss, personal injury, or
forecasts and therefore the estimate, how much coal will loss of life.
be demanded by the households in the coming winter.
Retail customers price will be inuenced by long-term
wholesale price trends. A certain hedging corridor around 6 Categories of hedgeable risk
the pre-dened tracker-curve is allowed and fraction of
the open positions decreases as the maturity date comes There are varying types of nancial risk that can be pro-
closer. tected against with a hedge. Those types of risks include:

Commodity risk: the risk that arises from poten-

4.3 Delta hedging
tial movements in the value of commodity contracts,
which include agricultural products, metals, and en-
Main article: Delta neutral
ergy products.[7]

Delta-hedging mitigates the nancial risk of an option by Credit risk: the risk that money owing will not be
hedging against price changes in its underlying. It is called paid by an obligor. Since credit risk is the natural
like that as Delta is the rst derivative of the options value business of banks, but an unwanted risk for com-
with respect to the underlying instrument's price. This mercial traders, an early market developed between
is performed in practice by buying a derivative with an banks and traders that involved selling obligations at
inverse price movement. It is also a type of market neutral a discounted rate.
strategy.
Currency risk (also known as Foreign Exchange
Only if BlackIsGreen chooses to perform delta-hedging Risk hedging) is used both by nancial investors
as strategy, actual nancial instruments come into play to deect the risks they encounter when investing
for hedging (in the usual, stricter meaning). abroad and by non-nancial actors in the global
economy for whom multi-currency activities are a
necessary evil rather than a desired state of expo-
4.4 Risk reversal sure.

Risk reversal means simultaneously buying a call option Interest rate risk: the risk that the relative value of
and selling a put option. This has the eect of simulating an interest-bearing liability, such as a loan or a bond,
being long on a stock or commodity position. will worsen due to an interest rate increase. Interest
rate risks can be hedged using xed-income instru-
ments or interest rate swaps.
5 Natural hedges Equity risk: the risk that ones investments will de-
preciate because of stock market dynamics causing
Many hedges do not involve exotic nancial instruments one to lose money.
or derivatives such as the married put. A natural hedge is
an investment that reduces the undesired risk by matching Volatility risk: is the threat that an exchange rate
cash ows (i.e. revenues and expenses). For example, an movement poses to an investors portfolio in a for-
exporter to the United States faces a risk of changes in the eign currency.
value of the U.S. dollar and chooses to open a production Volume risk is the risk that a customer demands
facility in that market to match its expected sales revenue more or less of a product than expected.
to its cost structure.
Another example is a company that opens a subsidiary
in another country and borrows in the foreign currency 7 Hedging equity and equity fu-
to nance its operations, even though the foreign interest
rate may be more expensive than in its home country: by tures
matching the debt payments to expected revenues in the
foreign currency, the parent company has reduced its for- Equity in a portfolio can be hedged by taking an opposite
eign currency exposure. Similarly, an oil producer may position in futures. To protect your stock picking against
 5

systematic market risk, futures are shorted when equity is money" because without the hedge they would have re-
purchased, or long futures when stock is shorted. ceived the benet of the pool price.
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 8 Related concepts
worth of Vodafone and shorting 10,000 worth of FTSE
futures (the index in which Vodafone trades). Forwards: A contract specifying future delivery of
an amount of an item, at a price decided now. The
Another way to hedge is the beta neutral. Beta is the his-
delivery is obligatory, not optional.
torical correlation between a stock and an index. If the
beta of a Vodafone stock is 2, then for a 10,000 GBP Forward rate agreement (FRA): A contract speci-
long position in Vodafone an investor would hedge with fying an interest rate amount to be settled at a pre-
a 20,000 GBP equivalent short position in the FTSE fu- determined interest rate on the date of the contract.
tures.
Option (nance): similar to a forward contract, but
Futures contracts and forward contracts are means of
optional.
hedging against the risk of adverse market movements.
These originally developed out of commodity markets in Call option: A contract that gives the owner
the 19th century, but over the last fty years a large global the right, but not the obligation, to buy an item
market developed in products to hedge nancial market in the future, at a price decided now.
risk. 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.
7.1 Futures hedging
Non-deliverable forwards (NDF): A strictly risk-
Investors who primarily trade in futures may hedge their transfer nancial product similar to a Forward Rate
futures against synthetic futures. A synthetic in this case Agreement, but used only where monetary policy re-
is a synthetic future comprising a call and a put position. strictions on the currency in question limit the free
Long synthetic futures means long call and short put at the ow and conversion of capital. As the name sug-
same expiry price. To hedge against a long futures trade gests, NDFs are not delivered but settled in a ref-
a short position in synthetics can be established, and vice erence currency, usually USD or EUR, where the
versa. parties exchange the gain or loss that the NDF in-
strument yields, and if the buyer of the controlled
Stack hedging is a strategy which involves buying various
currency truly needs that hard currency, he can take
futures contracts that are concentrated in nearby delivery
the reference payout and go to the government in
months to increase the liquidity position. It is generally
question and convert the USD or EUR payout. The
used by investors to ensure the surety of their earnings for
insurance eect is the same; its just that the supply
a longer period of time.
of insured currency is restricted and controlled by
government. See Capital Control.
7.2 Contract for dierence Interest rate parity and Covered interest arbitrage:
The simple concept that two similar investments in
Main article: Contract for dierence two dierent currencies ought to yield the same re-
turn. If the two similar investments are not at face
A contract for dierence (CFD) is a two-way hedge or value oering the same interest rate return, the dif-
swap contract that allows the seller and purchaser to x ference should conceptually be made up by changes
the price of a volatile commodity. Consider a deal be- in the exchange rate over the life of the investment.
tween an electricity producer and an electricity retailer, IRP basically provides the math to calculate a pro-
both of whom trade through an electricity market pool. jected or implied forward rate of exchange. This
If the producer and the retailer agree to a strike price of calculated rate is not and cannot be considered a pre-
$50 per MWh, for 1 MWh in a trading period, and if the diction or forecast, but rather is the arbitrage-free
actual pool price is $70, then the producer gets $70 from calculation for what the exchange rate is implied to
the pool but has to rebate $20 (the dierence between be in order for it to be impossible to make a free
the strike price and the pool price) to the retailer. prot by converting money to one currency, invest-
ing it for a period, then converting back and mak-
Conversely, the retailer pays the dierence to the pro- ing more money than if a person had invested in the
ducer if the pool price is lower than the agreed upon same opportunity in the original currency.
contractual strike price. In eect, the pool volatility is
nullied and the parties pay and receive $50 per MWh. Hedge fund: A fund which may engage in hedged
However, the party who pays the dierence is "out of the transactions or hedged investment strategies.
6 11 EXTERNAL LINKS

9 See also
Arbitrage
Assetliability mismatch
Diversication (nance)
Fixed bill
Foreign exchange hedge
Fuel price risk management
Immunization (nance)
List of nance topics
Option (nance)
Spread
Superhedging price
Accountant specic: IAS 39, FASB 133, Cash ow
hedge, Hedge accounting

10 References
[1] Morewedge, Carey K.; Tang, Simone; Larrick, Richard P.
(2016-10-12). Betting Your Favorite to Win: Costly Re-
luctance to Hedge Desired Outcomes. Management Sci-
ence. doi:10.1287/mnsc.2016.2656. ISSN 0025-1909.
[2] A survey of nancial centres: Capitals of capital. The
Economist. 1998-05-07. Retrieved 2011-10-20.
[3] Online Etymology Dictionary denition of hedge.
[4] Oltheten, Elisabeth; Waspi, Kevin G. (2012). Financial
Markets: A Practicum. 978-1-61549-777-5: Great River
Technologies. pp. 349359.
[5] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[6] Energiedienstleistungen Strom und Gas fr En-
ergiewirtschaft und energieintensive Industrieun-
ternehmen (PDF). citiworks AG. Retrieved 15
December 2015.
[7] Jorion, Philippe (2009). Financial Risk Manager Hand-
book (5 ed.). John Wiley and Sons. p. 287. ISBN 978-0-
470-47961-2.

11 External links
Understanding Derivatives: Markets and Infrastruc-
ture 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
 7

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