Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
Origins
The term is derived from the phrase "hedging your bets" used in gambling games such as roulette. The hedges on a roulette table are the lines between numbers or number groups. Placing a hedged bet is one where the chips lie across one or more hedges (i.e. on a line between two numbers or on a corner between three or four numbers). The bet then covers all the numbers involved at an appropriately reduced stake (e.g. 1/2, 1/3, 1/4).The term gradually moved into common usage within English-speaking cultures and today covers a broad range of risk-reduction activities or conditions.
In the finance lending industry, the term "hedge loan" has come to mean a specific type of financial product based on the melioration of price fluctuation risk in a stock portfolio serving as collateral for a nonrecourse debt structured stock loan.
Example hedge
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. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader were able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:
- Long 1000 shares of Company A at $1 each
- Short 500 shares of Company B at $2 each
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, goes up by 10%, while Company B goes up by just 5%:
- Long 1000 shares of Company A at $1.10 each — $100 gain
- Short 500 shares of Company B at $2.10 each — $50 loss
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):
- Day 1 — $1000
- Day 2 — $1100
- Day 3 — $550 => $450 loss
- Day 1 — -$1000
- Day 2 — -$1050
- Day 3 — -$525
Types of hedging
The 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.Natural hedges
Many hedges do not involve exotic financial instruments or derivatives. 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 local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local 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 of the oldest 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.
Categories of hedgeable risk
For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.- Interest rate risk – is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
- Equity – the risk, or sometimes reward, for those whose assets are equity holdings, that the value of the equity falls
- Securities Lending - Hedged portfolio stock secured loan financing (see HedgeLoan) is a form of individual portfolio risk reduction that results typically in a limited recourse loan.
Hedging credit risk
Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.Hedging currency risk
Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in
If the price of manufacturing goods in another country is fixed in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.
Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity.
Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).
The financial investor may be a hedge fund that decides to invest in a company in, for example,
As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.
