Whenever you come across the expression «risk management», you can be sure that it will soon come down to hedging. Why? The fact is that this practice has for many years been one of the main ways of insuring financial risks. In this article, we will discuss what it is about.
What Is Hedging
Hedging is understood as taking counter positions with respect to an asset in the market.
To give you an example: let’s say there is a company engaged in precious metals mining, but its analysts make a dismal forecast: they believe the prices of gold and other assets will fall in the near future. If it happens, the company will suffer major financial losses. The management decides to open a counter position on the exchange — to sell a certain number of futures contracts for gold. If it turns out that the experts are right, and the market really goes down, the money made from the transaction will balance off the losses from the price drop and the company will be saved.
On the other hand, if the forecast proves to be erroneous, and the prices of precious metals go up, the company will not get an extra profit because it will be eaten up by the losses from the deal. In other words, hedging helps you not so much to make money, as protect yourself against unpredictable losses.
Hedging and Trading
It is not only manufacturers of goods, but also their buyers, or traders, who hedge their risks. For instance, it is common practice to open counter transactions with respect to shares and futures, shares and options or even futures and options on one and the same asset.
To make it clear, let us define all these financial instruments:
- Share means a security making its holder an owner of a participatory interest in the issuing company and granting him the right to receive part of its income (dividends).
- Futures means a transaction under which the seller undertakes to sell and the buyer undertakes to purchase a certain quantity of an underlying asset at the price effective as of the contract execution date. As a rule, a futures buyer does not pay the full value of the futures, but only 10–15% thereof (the initial margin), but the profit or loss from the contract is calculated based on the total transaction value.
- Option means the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset at a fixed price on or before a specific date. An option is the most complex and multifaceted instrument available for hedging. It allows you to build so-called «option constructions» representing a combination of multidirectional transactions involving options on one and the same asset, but with different expiration dates.
Another instrument used for hedging is correlation (both direct and reverse) between different assets. For instance, the US dollar and euro move almost identically against other currencies, therefore, they can be treated as a combination enabling the development of various investment schemes.
The risks of large corporations and, sometimes, high net worth individuals are managed by special companies — hedge funds. A hedge fund is an investment fund that makes transactions on an exchange of behalf of its clients. For that purpose, the service provider (fund) and its client enter into an agreement defining all the details of their interaction. The agreement also specifies the desired return on investment, acceptable risks, the issues concerning the use of leverage, margin lending, etc.