In gambling terms, hedging your bets is when you take steps to protect yourself in case you made the wrong choice. It may be insurance or betting a small amount against the other side so that you don’t lose everything if your deal goes wrong. The same principles can be used in finance and hedging financial deals is routine for investors and businesses alike.
Here is an expert guide to financial hedging.
Hedging from a Hedge Fund Perspective.
Hedge funds are best known as the purview of the ultra-wealthy. However, when they were first founded, it was originally a small pooling of money like mutual funds but for more risk-averse investors. Hedging was a tactic to manage that risk. Hedge funds today are better known for investing in distressed companies before turning them around or investing private equity in businesses that others cannot invest in.
Methods of Financial Hedging.
A common method of financial hedging is to have a set of long positions and offsetting it with some short positions. Long-short equity funds invest specifically in this way, hence their name.
When this strategy is done for every long-term position, it provides good returns while limiting losses no matter what the market does. This does lessen your gains because you clearly lose on the “insurance”, but it prevents massive losses.
Derivatives like futures and options are regularly used as this type of insurance. For example, a farmer may sell “futures” for a price of X to guarantee that they receive at least that amount for their crop in the future. If the market goes up, the buyer has locked in their price and profits on the sale. If the price goes down, they may pay the farmer the difference between the options contract and the current market price while refusing delivery. Now the farmer has locked in that price, with the financial differential offsetting the low cost he gets for the product.
Options give someone the option to buy something at that set price but without the obligation to do so. The person with an options contract can choose to exercise the option and buy stock or commodities at that price. And they can sell the options contract to someone else who wants to buy the item at that contracted price.
However, to minimise risk to the seller of the original item, the options contract is good for a set period of time or must be exercised on a specific date. This allows the seller of the asset to know that they’re free to sell it at another price or to someone else after a certain amount of time has passed.
With hedging in finance explained, let’s discuss what isn’t hedging.
What Is Not Considered Hedging.
When you buy homeowners insurance, you’re reducing your risk in case something goes wrong, but this isn’t financial hedging. A business using foreign currency markets to secure a large sum of money in currency they’ll need later is hedging their bets that currency valuations won’t radically change, but this isn’t financial “hedging”.
Technically, financial hedging requires investing in two securities of some type of negative correlation, where if one goes up, the other goes down. Hedging has to be done carefully, since paying too much to hedge can wipe out the gains from the other investment. Hedging doesn’t eliminate risk, but it reduces the risk one takes while reducing the risk-return trade-off.
Hedging refers to specific financial instruments that lessen a business’ or investor’s risk when they enter a contract. They can be a great way to cover all bases, while still making significant and consistent returns.