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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 centuryto 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.
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 use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from the 1670s.
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.
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 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 clearinghouses. Clearinghouses ensure that every contract is honored and they take the opposite side of every contract. Future 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 future contracts. Future contracts also differ from forward contracts in that delivery never happens. The exchanges and clearinghouses 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.
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. He wants to buy Company A shares to profit from their expected price increase, as he believes 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, he wants 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 (the value, number of shares × price, is $1000 in both cases).
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), 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%:
The trader might regret the hedge on day two, since it reduced the profits on the Company A 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 Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Value of short position (Company B):
Without the hedge, the trader would have lost $450. But the hedge – the short sale of Company B – nets a profit of $25 during a dramatic market collapse.
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 [ citation needed ] 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.
Employee stock options (ESOs) 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,[ clarification needed ] to buy puts. Companies discourage hedging the ESOs but there is no prohibition against it.
Airlines 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 (and engaging in similar but more complex derivatives transactions), 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.
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. 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.
Hedging can be used in many different ways including foreign exchange trading. The stock 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.
Examples of hedging include:
A hedging strategy usually refers to the general risk management policy of a financially and physically trading firm how to minimize their risks. As the term hedging indicates, this risk mitigation is usually done by using financial instruments, but a hedging strategy as used by commodity traders like large energy companies, is usually referring to a business model (including both financial and physical deals).
In order to show the difference between these strategies, consider the fictional company BlackIsGreen Ltd trading coal by buying this commodity at the wholesale market and selling it to households mostly in winter.
Back-to-back (B2B) is a strategy where any open position is immediately closed, e.g. by buying the respective commodity on the spot market. This technique is often applied in the commodity market when the customers’ price is directly calculable from visible forward energy prices at the point of customer sign-up.
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 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 mitigates the financial risk of an option by hedging against price changes in its underlying. It is called like that 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 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.
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.
There are varying types of financial risk that can be protected against with a hedge. Those types of risks include:
Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased, or long futures when stock is shorted.
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 worth of Vodafone and shorting 10,000 worth of FTSE futures (the index in which Vodafone trades).
Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures.
Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.
Investors who primarily trade in futures may hedge their 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. To hedge against a long futures trade a short position in synthetics can be established, and vice versa.
Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.
A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. Consider a deal between an electricity producer and an electricity retailer, both of whom 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.
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed in 1936, are a more recent historical example.
A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.
Contango, also sometimes called forwardation, is a situation where the futures price of a commodity is higher than the spot price of the contract today. In a contango situation, arbitrageurs or speculators, are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.
Speculation is the purchase of an asset with the hope that it will become more valuable in the near future. In finance, speculation is also the practice of engaging in risky financial transactions in an attempt to profit from short term fluctuations in the market value of a tradable financial instrument—rather than attempting to profit from the underlying financial attributes embodied in the instrument such as value addition, return on investment, or dividends.
In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. This is the opposite of a more conventional "long" position, where the investor will profit if the value of the asset rises.
In finance, a futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. Futures exchanges provides physical or electronic trading venues, details of standardized contracts, market and price data, clearing houses, exchange self-regulations, margin mechanisms, settlement procedures, delivery times, delivery procedures and other services to foster trading in futures contracts. Futures exchanges can be organized as non-profit member-owned organizations or as for-profit organizations. Futures exchanges can be integrated under the same brand name or organization with other types of exchanges, such as stock markets, options markets, and bond markets. Non-profit member-owned futures exchanges benefit their members, who earn commissions and revenue acting as brokers or market makers. For-profit futures exchanges earn most of their revenue from trading and clearing fees.
A swap, in finance, is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
A currency future, also known as an FX future or a foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date.
An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset. It is a particular type of interest rate derivative.
In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.
In finance, a single-stock future (SSF) is a type of futures contract between two parties to exchange a specified number of stocks in a company for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to take delivery of the underlying stock in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to deliver the stock in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties - the buyer hopes or expects that the stock price is going to increase, while the seller hopes or expects that it will decrease. Because entering the contract itself costs nothing, the buy/sell terminology is a linguistic convenience reflecting the position each party is taking - long or short.
Proprietary trading occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money, aka the nostro account, contrary to depositors' money, in order to make a profit for itself. Proprietary traders may use a variety of strategies such as index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, or global macro trading, much like a hedge fund. Many reporters and analysts believe that large banks purposely leave ambiguous the proportion of proprietary versus non-proprietary trading, because it is felt that proprietary trading is riskier and results in more volatile profits.
The cost of carry or carrying charge is cost of storing a physical commodity, such as grain or metals, over a period of time. The carrying charge includes insurance, storage and interest on the invested funds as well as other incidental costs. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of the funds necessary to buy the instrument.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
The following outline is provided as an overview of and topical guide to finance:
In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.
Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal, and thus one profits by the amount of convergence.