What Is Hedging?

The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it every day. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

Although some of us may fantasize about a world where profit potentials are limitless but also risk free, hedging can't help us escape the hard reality of the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.

How Do Investors Hedge?

Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. We're not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative. Let's see how this works with an example. Say you own shares of Cory's Tequila Corporation (Ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the Tequila industry. To protect yourself from a fall in CTC you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

The other classic hedging example involves a company that depends on a certain commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would eat into profit margins severely. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less regulated cousin, the foreward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now CTC can budget without worrying about the fluctuating commodity. If the agave skyrockets above that price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and actually would have been better off by not hedging.

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency - investors can even hedge against the weather.

Fixed interest rate exposures

Fixed interest-bearing investments, such as an investment in long-term government stock or shorter term bankers' acceptances, have basically two definable risks: a) A specific risk that applies to each security; b) A general market risk relating to the entire portfolio of investments in fixed interestbearing securities. The specific risk of an individual security relates to the fact that individually it can move against the general market. This would mean that the individual security would decrease in value (the market rate on that security increases) when the general market value of interest-bearing securities increases (the market rate decreases). The general market risk is that the market value of interest-bearing securities decreases, because of an increase in the market interest rate. If securities in the investment portfolio follow the trend in the market, this increase in interest rates would result in a decline in the value of the portfolio. Increased interest rate volatility has led to greater volatility in the return on bonds and other fixed-income assets. The volatility of the interest rates and the resulting value of fixed interest rate securities, can lead to an unexpected capital loss. In the same manner the current value of interest-bearing liabilities can increase and decrease in value if the market rate fluctuates. The current value is arrived at by discounting the cash flows of the asset or liability back to the present date, making use of the current market rate.

Floating interest rate exposures

In the case of interest-bearing assets where the interest received is linked to a floating interest rate, the risk is that the floating interest rate would move negatively resulting in interest received on an investment (asset), such as cash kept on short-term deposit earning the prime rate, declining to less than the general money market interest rate or the expected yield. For the purposes of clarity the investment risks discussed above can be defined as: a) The risk of losses from holding capital; b) The risk of losses from interest income declining.

Derivative instruments and methods of hedging

When deciding on a technique to hedge a risk associated with a financial position, a number of aspects have to be taken into account. Some of the aspects to be considered are named below:

The risk inherent to the derivative. Some derivatives have other risks associated to them that are not inherent to the original underlying position, such as immediate cash flow, the risk of the downside, etc. The risk of the specific derivative being considered must be taken into account before deciding on a strategy. Exposure to the downside. When certain instruments are bought or sold, a risk exists that the market does not move as anticipated, and that a larger loss will be suffered on the hedging than previously expected. On certain instruments this loss is unlimited and it is possible to suffer large losses because of this position. On some instruments the downside (loss opportunity) is limited, such as purchased options Cash flow of the hedging method. When making use of futures as a hedge, there could be daily cash flow as opposed to caps or floors, where cash flow is only on settlement dates and only if the benchmark rate was exceeded. This cash flow planning needs to be considered when deciding on a hedging method. Effectiveness of hedge. Sometimes a hedge is not a perfect hedge, in the sense that no direct derivative exists for the underlying position that needs to be hedged. This would, for instance, be the case where a share portfolio exists which does not represent the allshare index, but the value of the portfolio moves more or less in line with the all-share index. To hedge this portfolio with a short all-share index future, there is a risk that the short all-share index future and the value of the portfolio move in corresponding directions resulting in losses on both sides. If no perfect hedge exists, the risk of the hedge corresponding to the movement of the underlying asset must be taken into account. Tradability of derivatives used. In some cases the market does not move as anticipated, and the underlying position makes a profit while the hedging position suffers a loss. In these cases it would be preferable if the hedging position could be sold in the market and closed out. This can, however, only be done if the instruments used in the hedge have an active secondary market and can be traded easily. Joint enhancing strategies. Some hedging strategies, such as the writing of options, have only limited upsides. In such cases other policies or strategies must be implemented to stop the loss from exceeding the possible profit on the hedging position. An example of such a strategy is a stop-loss limit where a policy decision is made to liquidate a position should that position suffer a larger loss than a certain set limit.

Options Hedging fixed interest rate investments or non-interest-bearing investments with option contracts When an investment is made in a fixed interest-bearing instrument, the risk is that the secondary market rate at which these instruments trade will increase, with a resulting decrease in the value of the instrument. Investments in non-interest-bearing assets such as shares, carry the risk that prices may decrease, resulting in a loss of value. This risk can be hedged by buying a put option with the investment as the underlying asset. The put option will establish investment as the underlying asset. The put option will establish the rate or price at which the underlying asset can be sold to the writer of the option. The maximum possible loss (or minimum possible profit) is thus known. If the rates decrease or the prices increase beyond the strike price of the option, the asset can be sold in the market at a higher value than would be the case if the option were exercised. In this case, the option would not be exercised, and the loss on the hedge is the option premium paid. If the investor is of the opinion that rates will increase, with the result of decreasing prices of assets, the investor may also write and sell a call option at current rates or rates that are expected to be less than future rates. If the rates increase, the option will most probably not be exercised, and the investor would have made a profit equal to the option premium received when the option was sold. This is, however, not a full hedge of an underlying investment, as the maximum profit that can be made is limited to the premium received. The decline in the price of the investment might be more than the premium received. To enhance this strategy, an additional measure such as a stop-loss limit on the underlying asset should be put into place. Hedging floating interest rate investments with option contracts Option contracts, as seen previously, gives a right to but does not place an obligation on the holder. When an OTC option is exercised, in most cases the underlying asset is physically delivered. Options can be applied to floating-rate investments in the same manner as with fixed-rate investments, where the underlying instrument can physically be delivered. Where the investment is a cash amount, for instance, in a short-term deposit, in some cases this asset cannot at will be liquidated and delivered for the exercising of an option. Terms of an option are, however, in most cases negotiated between the two parties, and it is not impossible to negotiate an option that suits the investor. These options with customized terms are, however, not common and often cannot be traded effectively in the secondary market. Options traded on an exchange such as options traded on SAFEX are, however, cash settled in most cases and can effectively be used to hedge an income stream if movements in the rate of the underlying asset of the option and the rate of the position that needs to be hedged, coincide.

Futures Hedging fixed interest rate exposures and non-interest-bearing instruments with futures contracts An investor can guarantee a minimum price that he would get for his asset by selling a future (closing a future contract to sell the underlying asset). One of the major disadvantages of the future (in comparison to options, for instance) is that a futures contract places an obligation on both parties to honour the terms of the contract. There is no choice whether to exercise the contract or not. The investor could thus be forced to sell the underlying asset at the close-out date of the contract at a price that is lower than the market value of the underlying asset at that date. A prospective investor can determine the price at which he will buy the investment at a future date, by buying a future (closing a contract to buy an asset at a future date). This could, however, force the investor to buy the investment at a higher value than the market value at the close-out date of the contract. As is the case with options, when dealing with futures where the underlying asset is a fixed interest rate asset, the futures contract will specify the rate at which the asset will be bought or sold. The price will be the future cash flows discounted at the rate stipulated in the futures contract. Hedging floating interest rate investments with futures Similar to options, futures were mainly developed to determine and establish a fixed price received on an investment at a certain date in the future. It was not specifically intended to hedge risks associated with floating-rate investments, although this risk can be managed if a financial future with an interest rate instrument as underlying asset is available, and the market rate movements on this instrument more or less matched the floating interest rate of the investment. The risk for the investor in a floating interest rate product would be that the rate and income stream from the investment decreases. The fact that futures are cash settled and not physically delivered gives this investor the chance to establish an interest rate (income stream received) for a future date, if he can match the nominal amounts of his investment and the futures contract. By closing the futures contract now, the investor can fix the yield on his investment for the period of the futures contract. It is important to note that the yield can only be determined if the floating rate on his investment matches the market rate of the underlying asset to the future.