Hedging. What is Hedging?

Price Hedging

The most basic hedging is hedging market risk whereas a market facilitator takes long and short positions in an instrument to cancel the risk of a price change in that security. By hedging the price risk, market makers can hold an inventory of securities without concern as to the change in price of that security.

Event Hedging

One might want to hedge against a certain event for example, who will win the presidency of the United States. By playing both sides, an investor is able to hedge his or her bets in terms of the event of who wins the presidency.

Partial Event Hedging

One might want to hedge his or her bets probabilistically. For instance, a man might try to pursue two women simultaneously trying to hedge his bets that if one does not respond to his wooing the other might respond. The pursuing of two women, however, does not guarantee that one will respond positively, and so it is just a partial probability hedging. On the other hand, full probability hedging would imply that the even of being accepted by one woman would occur with probability one.

Hedging Different Variables

Hedging can become very complex. In terms of securities, one can try to hedge virtually any variable. It is just a matter of finding an instrument or set of instruments that will be able to cancel the change in that variable as compared to the original instrument.

There is alpha hedging, beta hedging, delta hedging, gamma hedging and the list is only limited by the imagination and instruments available.

For instance alpha hedging just means that you want your returns to be constant, say 15% per year every year without any disturbance or perturbation. For that you would need a security with a fixed payout ratio. The insurance companies or other companies selling the security would have to see how to balance different instruments to get you that 15% per year, every year.

Beta hedging means that no matter what the markets do, you get a given return. That is no matter if tomorrow or next year, the market rises or declines 10%, you get a given amount regardless of market conditions.

Traditionally, hedge funds are concerned about alpha, that is, absolute returns. So that no matter what the markets do, they get an absolute sizeable return. Well, that is why they were called from the early days hedge funds, because they supposedly got rid of beta or change in the market indices by going short some securities that were more likely to go down than the market and long securities that were more likely to rise higher than the market. On average, these securities would cancel market action, and an absolute return would be left for the investor.

Currently though, hedge funds take all kinds of positions. There are long-only hedge funds, short-only hedge funds, global macro directional hedge funds, high-frequency hedge funds, and you name it. There is no shortage of new investment strategies and philosophies. Some people hedge their bets by investing in hedge funds with different strategies. They are all different ways of hedging.

Investment banks that were overleveraged before the crisis thought they were hedged because they had all sorts of securities, however, during a large crisis many instruments move in the same direction and hedges that typically work, don’t work in these cases. Thus, as the value of most securities declines banks were forced to sell themselves or ask for federal assistance. Hedging is more easily talked about than actually done. There is no way to really hedge in practice, only in theory, in expectation. You can take the historical probabilities and based on that you can do some hedging, but the outcomes of those probabilities can be vastly different to the average historical outcome. That is why institutions that are leveraged 30-1 cannot survive in the long run, because when a low-probability event hits them, even if they are hedge and the correlation breaks down, they will not survive.

Dr. Nassim Taleb argues that those low-probability events that occur are grey swans, that is, people know they will happen, they just hope they don’t occur during their stance with the investment bank. Others, however, have never occurred or people don’t think they will ever occur, and those are the genuine black swans to which no hedging is even possible. That is why he argues that financial entities should take positions that are robust to those grey and black swans. That is, become less leveraged and less scientific in their risk management as scientific precision makes people believe that things can be very well planned when they clearly cannot be. It is a mirage brought about by sophistication. People fall into this illusion where high levels of probability knowledge compensate for high levels of ignorance about the future, and the person believes it is in control if he or she can only get the hedging right.

Approximate Hedging

Sometimes the only available hedge is to hedge with a correlated instrument. For instance if one wants to protect against the change in price of chocolate one could use the cocoa futures. However, cocoa only correlates with chocolate and given the inability to hedge directly chocolate the hedge is just approximate. It could happen that during a given time period the prices of both commodities go in different directions thus not hedging, but magnifying the price change.

Hedging is not always necessary. Oftentimes it reduces possible returns. It would be better to say, “the worst-case scenario I don’t loose, best case scenario, I win a lot.” That is not strictly hedging and it can get better results in the long-run than always hedging.

So, what is hedging? It is the act of at least partially canceling the risk of a certain event, factor, or price change.

Hedging Funds

What are hedging funds? Well, technically, hedging funds would properly be called hedge funds. However, hedge funds do not necessarily hedge. Hedging funds would in theory be those funds which engage in hedging, but more likely it is just an odd way of naming hedge funds.

Hedging Example

Through a relatively complex but systematic method, investors can realize their price objectives through hedging. Depending on the size of investment and investment vehicles chosen, a plethora of methods and tools are deployed by hedge funds and hedge fund managers to limit the downside to their portfolio. Let us consider the import/export scenario for instance:

The value of most imports/exports across the globe is generally expressed in US dollars, though it is not uncommon to opt for other hard currencies. In the foreign exchange markets, currency values fluctuate continuously and throughout the week 24/7 essentially. An exporter prices his product in relation to the local currency that is available against the dollar. However, during the time lag between physical export and receipt of related payment, the exchange rate can move either way. The exporter is happy if the local currency available from the payment received, say after 90 days is more than what he expected because his local currency depreciated against the dollar. But when the reverse is true, the exporter incurs a loss. Instead, immediately upon physical export of the goods, the exporter enters a contract through his bankers to sell a designated quantity of dollars on the date prescribed for payment by the importer.

The bank charges a small premium for this contract while the exporter is assured of a fixed rate of exchange. In other words, hedging can be understood as an insurance against exchange rate risk in this case. Remember however, that the description of the topic here is not exhaustive in character.