Basic principles. The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against the impact of an adverse event on their finances. This does not prevent all negative events from happening. However, if an adverse event does occur and you hedge properly, the impact of the event is lessened.
In practice, hedging happens almost everywhere. For example, if you buy home insurance, you protect yourself against fires, thefts or other unforeseen disasters.
Portfolio managers, individual investors, and companies use hedging techniques to reduce their exposure to a variety of risks. But hedging risk in financial markets is not as simple as paying an insurance company a fee each year for coverage.
Hedging investment risk means using financial instruments or market strategies strategically to offset the risk of any adverse price movements. In other words, investors protect one investment by trading in another.
Technically, hedging requires you to make offsets on negatively correlated securities. Of course, you still have to pay for this type of insurance one way or another.
For example, if you are long on company XYZ stock, you can buy a put option to protect your investment from major downside moves. However, to buy an option, you have to pay its premium.
A reduction in risk therefore always means a reduction in potential profits. Thus, hedging is mostly a technique aimed at reducing a potential loss (and not maximizing a potential gain). If your hedging investment is making money, you're often reducing your potential profit as well. However, if the investment loses money and your hedge is successful, you have reduced your loss.
In the markets. Hedging techniques often involve the use of financial instruments known as derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop trading strategies where the loss on one investment is offset by the gain on a derivative.
Let's say you own stock of Cory's Tequila Corporation (ticker: CTC). While you believe in the company for the long term, you worry about some short-term losses in the tequila industry. To protect yourself from the drop in CTC, you can buy a put option from the company that gives you the right to sell the CTC at a certain price (also called the strike price). This strategy is known as the married put. If your stock price falls below the strike price, these losses will be offset by the gains on the put option.
Another classic example of hedging involves a company that is tied to a particular commodity. Suppose Cory's Tequila Company is concerned about the price fluctuation of agave (the plant used to make tequila). If the price of agave skyrocketed, the company would be in big trouble because it would seriously affect their profits.
To hedge against the uncertainty of agave prices, the CTC may enter a futures contract (or its less regulated relative forward contract). A futures contract is a type of hedging instrument that allows the company to purchase agave at a certain price on a certain date in the future. Now CTC can budget without worrying about the fluctuating price of agave.
If the agave spikes above the price stated in the futures contract, this hedging strategy will have worked because CTC will save by paying the lower price. However, if the price drops, CTC is still obligated to pay the contract price. And therefore, it would be better if they were not hedged against this risk.
Because there are so many different types of options and futures contracts, an investor can hedge against almost anything, including stocks, commodities, interest rates or currencies.
Example in a fluctuating market. A classic example of hedging involves a wheat farmer and the wheat futures market. The farmer sows his seeds in the spring and sells his harvest in the fall. In the intervening months, the farmer is exposed to the price risk that the wheat will be lower in autumn than it is now. While the farmer wants to make as much money as possible from his harvest, he does not want to speculate on the price of wheat. Therefore, when he sows his wheat, he can also sell a six-month futures contract at $40 per bushel. This is known as a forward hedge.
Suppose six months have passed and the farmer is ready to harvest and sell his wheat at the prevailing market price. The market price has indeed dropped to just $32 per bushel. He sells the wheat at that price. At the same time, he repurchases the short-term contract for $32, making a net profit of $8. Therefore, he sells his wheat at $32 + $8 hedge profit = $40. He essentially locked down the $40 price when he planted his crop.
Now suppose the price of wheat rises to $44 per bushel. The farmer sells his wheat at this market price and also buys back his short-term trades at a loss of $4. His net income is therefore $44 - $4 = $40. The farmer limited his gains as well as his losses.
Conclusion? Risk is a fundamental but also dangerous element of investing. Regardless of what type of investor you aspire to be, having a basic knowledge of hedging strategies will lead to a better awareness of how investors and companies work to protect themselves.
Whether you've decided to start practicing the complex uses of derivatives or not, learning how hedging works will help you improve your understanding of the market, which will always help you become a better investor.
Kaynak:Tera Yatırım-Enver Erkan
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