10/05/2020
What Is a Hedge?
A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.
Understanding a Hedge
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; “basis” refers to the discrepancy.
How Does Hedging Work?
The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If one year later STOCK is trading at $12, Morty will not exercise the option and will be out $5. He’s unlikely to fret, though, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205 including the price of the put). Without the option, he stood to lose his entire investment.
The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the “hedge ratio.” Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.
Fortunately, the various kinds of options and futures contracts allow investors to hedge against most any investment, including those involving stocks, interest rates, currencies, commodities, and more.
The specific hedging strategy, as well as the pricing of hedging instruments, is likely to depend upon the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the hedge. Downside risk tends to increase with higher levels of volatility and over time; an option which expires after a longer period and which is linked to a more volatile security will thus be more expensive as a means of hedging. In the STOCK example above, the higher the strike price, the more expensive the option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option which offers less protection, or a more expensive one which provides greater protection. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost effectiveness.
