Hedge your investments


hedge your investmentsWhen an investment is made specifically to mitigate a risk arising from another investment, it is called hedging. Hedging is not only carried out by professional investors, but by companies, organization, individuals and other entities that wants to mitigate risk.

Many different financial instruments can be used to achieve a hedge, including stocks, forward contracts, futures contracts, options, and swaps – just to mention a few. Hedging can also be achieved without using any financial instruments, but that it is more unusual.

 

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Examples of risks that you can hedge against

  • Currency risk / Forex risk
  • Commodity risk
  • Interest rate risk
  • Credit risk
  • Equity risk
  • Volumetric risk

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Examples of hedging strategies

  • If you want to hedge against potential losses caused by changes in interest rate, you can for instance use futures contracts, forward exchange contracts or money market operations.
  • Potentially losses caused by shifting currency exchanges, can for instance be hedged using forward exchange contracts, currency futures contracts or money market operations.
  • For mitigation against equity risks, covered calls and short straddles are popular.

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Natural hedges

A natural hedge is an investment that reduces undesired risk without using financial instruments. An export company based outside the United States, that gets its income in U.S. dollar, can for instance mitigate currency risk by paying local workers in U.S. dollars instead of paying in local currency.

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Double hedging

Double hedging is when you hedge a position by using futures and options to double the size of the hedge, and bring it up to a level that is greater than the exposure to risk. Double hedging can be seen as a combination of hedging and speculation.

Example: A trader holds a long futures position in coffee beans in excess of the speculative position limit to offset a fixed priced sale, even though the trader has enough supplies of coffee beans to fulfill all sales commitments.

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To de-hedge

De-hedging is when you close out positions that were originally put in place as hedges.

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How to hedge – practical examples

Example A

hedgeYou own shares in Company NNN. Company NNN manufactures luxury products, and is therefore rather sensitive to economic cycles. During economic slumps, their sales go down significantly.

You wish to mitigate this risk by hedging. One way of doing this is to purchase stocks in a company that you believe will do well in an economic slump. You find Company OOO, a food company specializing in cheap basic necessities. You believe that Company OOO wouldn’t just do okay in an economic slump – they would actually increase sales.

So, to mitigate your risk in Company NNN you purchase shares in Company OOO as well.

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Example B

You own shares in Company NNN. Company NNN manufactures luxury products, and is therefore rather sensitive to economic cycles. During economic slumps, their sales go down significantly.

You wish to mitigate this risk by hedging, and you decide to purchase a put option contract on the shares. With the put option contract, you lock in a sales price for the shares. You have the right (but not the obligation) to sell them for the pre-specified price in the future. With an American-style put option you carry out the sale at any day until the option expires. With a European-style put option, the sale can only take place on the expiry date.

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Example C

You own Company CCC, a company that produces rum from sugar cane. If the price of sugar canes were to increase, it would seriously diminish the company’s profits, and if the price of sugar cane went high enough the company would not make any profit at all on their rum.

To mitigate this risk, you decide to enter into a futures contract that gives you the right to purchase 4,000 kg of sugar cane at a pre-specified price at a set date in the future.

Another option would be to enter into a forward contract, a type of contract that is similar (but not identical) to futures contracts.

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Should I hedge my investments?

hedgingHedging is a bit like purchasing insurance. When you purchase home insurance, you are paying money to protect you from the consequences of an undesirable event. Your insurance will not prevent the event from taking place, but it will protect you from certain bad consequences of the event, such as financial loss. It is up to you how much you are willing to pay for insurance. Some people want a very comprehensive insurance policy and a low deductible, and are willing to pay a large monthly premium. Others are less adverse to risk and decide to go with a low-premium insurance that only covers the basics and have a pretty big deductible.

The same is true for hedging. Some investors are highly adverse to risk and are willing to hedge their entire stock portfolio even if it means a reduced profit on the original investment. Others only want to hedge a part of their investment, and want to keep the costs associated with hedging low.

Hedging means paying a price to mitigate uncertainty. Some investors are more okay with uncertainty than others, and an individual can also decide to take large risks with one of his investments while carefully hedging another one.

As you can see, there is no clear answer to the question “should I hedge”. It all depends on the circumstances, such as why you are investing, the time-frame of your investment and your personal preferences regarding risk and uncertainty for this specific investment.