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Hedging In Finance

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by Gavin in Blog
October 5, 2021 0 comments
hedging in finance

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Chances are you’ve already applied the concept of hedging in finance many times during your life.

For example, that health insurance card you carry in your wallet is a hedge against financial ruin in the event of a medical emergency.

You can say the same about your car and home insurance.

You are paying a premium to ensure you don’t suffer financial loss in the event of a fire, accident, or health issue.

Hedging can be thougt about it in non-monetary terms.

For example, you wear a seat belt to ensure you survive a major accident because your life is precious.

Or you get to the airport two hours early because you don’t want to miss your flight.

What Is Hedging?

In the financial world, hedging works the same way as the examples from your personal life.

As you know, most investments, trades, etc., involve a certain degree of risk.

By paying a premium, you reduce that risk in the event of a market crash, inflation, or loss in currency value.

Financial hedging is the practice of managing this risk through financial derivatives to offset price movement.

Historical Context

The word hedging comes from Old English and essentially means a fence – to protect yourself.

Even though hedging as a notion dates back centuries, when ancient civilizations hoarded precious metals to protect themselves against calamities, the modern idea of hedging in finance is generally attributed to Alfred Winslow Jones.

In 1949 he set up an investment firm with $40,000 of his own money and $60,000 from friends.

Jones referred to his fund as “hedged” and set up the first “hedge fund.”

hedging in finance

Jones pioneered the concept of buying long positions while at the same time reducing his risk by short selling other positions, minimizing his risk.

Don’t worry if you don’t know what long and short positions refer to; we will cover them later.

Amazingly, no one noticed Jones’ “Hedge Fund” until 1966, even though it had made him extraordinarily wealthy by that time.

However, after being published in an article in Fortune magazine, the story became so popular that immediately 130 hedge funds set up shop, and by 2021 there are upwards of 3600 hedge funds in the US alone.

Different Types of Risks

Besides the traditional “Hedge Funds,” many risks need to be managed in the financial industry.

A lot of them are done by large corporations, commodity traders, and financial institutions.

It’s essential to understand the different types of risk when you are investing or involved in any business:

Securities Risk

When an investor invests in a stock or mutual fund, they expect it to gain value and net the investor a decent profit.

Unfortunately, even though hundreds of hours of research go into each investment, these investors still cannot eliminate the risk that the stock price won’t plummet due to some unforeseen circumstance or miscalculation.

Commodities Risk

We can say the about commodities like wheat, soy, corn, oil, gas, etc.

If you are buying or selling these commodities, there is a risk that the prices will change in the future. As a buyer, you risk prices rising compared to what you expected to pay.

As a seller, you risk prices falling compared to what you expected as revenue.

Currency Risks

Companies that trade with foreign companies usually pay those companies in foreign currencies for goods or services received.

Because of exchange rate fluctuations, there’s a risk that an agreed-upon price in a foreign currency will cost more in the future if the local currency loses its value.

Interest Rate Risks

Another risk involved in any financial transaction is rising or falling in interest rates, which could be detrimental depending on the business.

How Does An Investor Hedge Against These Risks?

Hedging A Stock Price

One strategy used is the long/short Method.

A long position means the investor will make money if the stock price rises.

A short position is the opposite, where the investor will make money if the stock loses value.

As an investor, you are very optimistic about the airline industry and see potential growth because of the exploding demand for travel.

You, however, don’t want to assume too much risk because of the ongoing pandemic.

So you decide to initiate two positions: A long position in Delta Airlines (DAL) and a short one in United Airlines (UAL).

You buy 100 shares of Delta for $40 = $4,000

You short 100 shares of United for $50 = $5,000

Now let’s say after a week, travel is booming, and the stock prices for both Delta and United rise. Delta rose by 10% and United by 5%

You have 100 shares of Delta now worth $44 = $4,400

You have -100 shares of United for $52.5 = $5250

Net Profit

Your Net Profit is 400 – 250 = $150 – Remember, you lose value when United Airlines’ share price increases.

At this point, you may feel it was a terrible idea short-selling United stock.

But let’s say the next week, a new variant of the virus hits, and all travel is banned.

The stock price plunges 30% for Delta and 40% for United in a single day

You now have 100 shares of Delta at $30.8 = $3,080

You have -100 shares of United at $31.5 = $3,150

Your loss with Delta is significant compared to your original investment. $4,000 – $ 3,080 = $920 loss

However, because United Airlines stock fell and you benefit when it falls, you made a profit of $5000 – $3,150 = $1,850 gain.

Thus even though both stocks fell substantially, you still made a profit of $1,850 – $920 = $930.

Using Options to Hedge

Another Strategy used is buying what’s called a put option.

In this, let’s say you decide to only buy 200 shares of Delta stock at $40 a share = $8,000

You also decide to buy a put option which is the right (not obligation) to sell a stock within a particular time frame for a set price.

For example, let’s say you buy a put option for one year, during which time you can sell the stock for $20 per share if needed.

The price for purchasing this put option is $200.

If, after a year, the stock price stays above $20 per share, then obviously you don’t exercise your put option, and you lose the $200 in option premium.

However, if the stock price nosedives within the year and is worth less than $20, then you can always exercise your put option and minimize your losses by selling your shares for $20 per share.

This strategy effectively puts a floor on the losses you sustain with any stock.

Hedging Commodities

Let’s say, Joe, the farmer has 1 million bushels of wheat he plans on selling in 6 months. However, he is worried about the price of wheat in the future.

So, he decides to go to an exchange and sell his wheat bushels in the futures market for $7 per bushel.

At the same time, Harry, the Baker, decides to buy wheat in the futures market to make his bread at $7 per bushel.

If the price of wheat increases to $8 per bushel in 6 months, farmer Joe loses out on $1 per bushel profit.

On the other hand, Baker Harry thanks his lucky stars for saving $1 per bushel.

However, if the price of wheat decreases to $6 per bushel in 6 months, farmer Joe now thanks his lucky stars for selling his wheat at the agreed-upon price of $7 per bushel.

On the other hand, Harry is obligated to buy the wheat also at $7 per bushel even though he knows the price is lower now in the open market.

A very famous example of this type of hedging was in the 2000s when Southwest Airlines bought long-term contracts for oil at $51 per barrel.

After the Iraq War and Hurricane Katrina, when fuel prices rose above $100 per barrel, Southwest was killing its competition because it could keep its operational costs substantially low.

Hedging Currencies

Currencies are hedged using either forward contracts or options.

For example, a US company is doing business with a German company and needs to pay them in Euros. The agreed-upon price is 1,000,000 Euros.

That roughly translates to $1,174,000 at today’s Exchange Rate.

However, let’s say in the future, the US Dollar loses its value, and now 1 EUR = $1.2 making the purchase price $1,200,000 in local currency, a loss of $26,000.

However, the company already had a contract with a financial institution to buy Euros at the set rate of 1 EUR = $1.174, so it doesn’t lose that money.

This hedging provides companies stability in operating costs, especially when they have large trade volumes in foreign currencies.

Hedging Through Diversification

Here is an example many of us are familiar with very well.

When your financial planner tells you not to put all your eggs in one basket, he is essentially hedging against the risk of investing in a few stocks and seeing your portfolio value collapse due to market volatility or some unforeseen circumstances.

When you invest in multiple stocks, mutual funds, and bonds, you spread your risk and avoid severe losses that can happen with sudden downturns and recessions.

Difference Between Forward And Future Contracts

Forward Contract

A forward contract is considered an over the counter (OTC) contract because it is not traded on any exchange.

It is a contract between two parties to buy/sell any asset for a price specified in the contract at a future date.

Futures Contract

Futures contracts are similar to forward contracts, except they are traded on an exchange.

Therefore, the terms of the contract are more standardized, unlike the forward contract, which can be customized as the parties see fit.

Pros and Cons of Hedging

Hedging works for many investors, but most investors will never need to use the more complicated hedging techniques.

That’s because most ordinary investors already hedge against risks through diversifying their portfolios.

However, those who use hedging as an Investing tool find it beneficial and lucrative.

As mentioned in the examples above, if you trade in commodities and foreign currencies, as a farmer or a large corporation, you reduce your operational risks by setting prices for future trades through hedging.

A fixed price, whether buying or selling oil, gas, wheat, corn, soy, etc., or a fixed exchange rate when trading with a foreign currency, allows you to plan financially and be more secure about prices in the future.

The biggest con, however, for hedging is it is expensive and, in the end, might be unnecessary—this, of course, on top of the fact that hedging, especially in stocks, can be highly complicated.

For example, in our example above about Delta and United, we assumed that both stocks would either rise or fall together as demand for travel increases or decreases.

But you could also face the situation where the price for shares of Delta Airlines goes down, and United Airlines goes up simultaneously, effectively doubling your losses.

Conclusion

It’s crucial to understand hedging and how it works in the financial world. At the same time, hedging is not for everyone.

For most investors applying bubble wrap to your portfolio might hinder its performance.

However, it is an effective tool for large corporations, commodity traders, and hedge fund managers to reduce risk or guarantee future costs.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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