WHAT IS HEDGING?
The best way to understand the concept of “hedging” is to think of it as a type of insurance. Hedging in its simplest form refers to an action or investment strategy which aims to protect the investor from a potential loss in investment value. When an investor decides to hedge, the investor is insured against a negative, unforeseen or extreme event (i.e. a “black swan”).
Hedging in the financial markets may require the investor to actively use derivative instruments to offset the risk of any potential adverse price movements on their investments. Of course, nothing in this world is free and therefore the investor pays for insurance or hedging in one form or another.
HEDGING TYPES AND TERMINOLOGY
A derivative instrument is a contract or option whose price depends upon or is derived from one or more underlying assets. Underlying assets may include equities, bonds, commodities, currencies, interest rates and market indices. In its broadest form, commonly used derivatives include, inter alia, the following.
Forward/futures contract – A financial contract that obligates the buyer to purchase an underlying asset from the seller on a specified future date at a predetermined price.
Key differences – Futures contracts are highly standardized whereas the terms of each forward contract can be privately negotiated. Futures are also traded on an exchange (liquid) whereas forwards are traded over-the-counter.
Option contract – A financial contract that provides the holder with the right (not the obligation) to buy or sell a predefined underlying asset at a predetermined price within a specified time.
PROS AND CONS OF HEDGING
Every investment is unique in nature and the investor should therefore determine the potential benefits from implementing a hedge and compare such with the related cost thereof:
- Hedging strategies which use futures and options can be used as short-term risk-minimizing strategies for long-term investors.
- Hedging strategies can protect profits already made without capitalizing such profits and exiting the investment.
- Hedging strategies provides the investor with protection against a variety of risks, e.g. commodity price changes, inflation surprises, currency exchange rate changes and/or interest rate changes.
- Hedging strategies which uses listed derivatives creates a protection strategy that is liquid, transparent (due to daily valuation) and with no credit risk to a counter party bank.
- Hedging strategies may be complex and involves costs that may erode returns to an extent over the long term.
- Hedging strategies using listed index derivatives may expose an investor to a potential mismatch risk of the underlying asset to be hedged and the index derivative exposure used to hedge such is not exactly the same.
CONSIDERATIONS WHEN SELECTING A SUITABLE HEDGING STRATEGY
Hedging strategies will vary according to the needs of every investor. Key considerations, amongst others, in order to construct a suitable hedging strategy are:
Does the investor require full or partial protection e.g. does the investor require 100% protection against extreme losses (“black swans”) or alternatively prepared to carry a portion of the market loss before any protection kicks in?
Is the investor prepared to sacrifice some upside potential in order to gain the benefit of downside protection? Alternatively, is the investor prepared to pay an additional premium in order to retain the full upside potential?
What duration of time does the investor require protection for? This will be influenced by the motivation for hedging as well as the investor’s expectation of how long the market will be in a certain position.
Investment markets are unpredictable in the short term and may deviate from what is expected. Extreme events (“black swans”) are occurring more frequently than in the past. When they occur they have massive consequences.
Hedging is a risk reduction or risk management strategy in the arsenal of the investor. Hedging could add significant value when an investor wishes to secure a certain outcome or investment objective.
Hedging should therefore be considered as a complementing strategy, rather than a substitute, to other portfolio management techniques such as strategic and tactical asset allocation, diversification and ongoing rebalancing.
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