There are several risk management strategies that are used to protect assets from potential losses, and a hedge is one of them. A hedge can consist of many types of financial instruments, such as derivatives, exchange-traded funds (ETFs), forward contracts, gambles, futures contracts, insurance, options, stocks, and swaps.
What Is a Hedge?
A hedge is an investment made to reduce the chance of risky price movements in an asset. A hedge typically involves taking an offsetting position in relevant security. Simply put, it is something like an insurance for assets that you invest in. And, just like with insurance, you need to pay for hedging.
The Origins of Hedging
The word “hedge”, originally meaning a natural fence put on a land plot, first appeared in the 1600s. In the mid-1800s, Chicago became a commercial center of the industry due to a powerful railway network. During that time, a concept of commitment emerged. This concept was close to modern hedging, - here's how it appeared.
Farmers were selling grain to dealers who would then ship their grain across the country. Often the offer exceeded the demand. There were fewer dealers than farmers, so they often wanted to buy a lesser quantity of grain than the farmers were ready to offer. As a result, the farmers were “overstocked” and the remaining grain quantity was just wasted, bringing financial issues. However, around 1848, farmers and dealers came up with an idea.
A farmer would ask a dealer if they were willing to commit to buying grain at a specific agreed price today to be paid in the future when the grain was delivered, typically next year. In case of agreement, the farmer and the dealer made a two-sided “commitment”. According to this commitment, the farmer had to deliver the grain at the agreed price and the dealer had to buy the grain at the same price. The farmers were able to plan the production for the next year and thus secure their gains.
These events resulted in the establishment of the Chicago Board of Trade whereas other exchanges developed similar “commitments” for other commodities. And this brought us to the modern concept of hedging that we know today. The “hedge fund” term was coined in 1949 by Alfred Winslow Jones, a reporter at Forbes.
In his article, Jones observed that investors could make higher gains by implementing hedging strategies. To prove his hypothesis, Jones created an investment partnership by using 2 investment tools - leverage and short selling - to minimize risk and enhance returns. He achieved great results. Between 1962 and 1966, the fund was ahead of the best mutual fund by over 85%.
Today, hedge funds are a significant segment of the investment management industry, with more than 6,000 individual funds with a total market worth over $1 trillion.
Examples of Hedging Strategies
There is a wide variety of hedging tools, techniques, and strategies, such as:
Being a form of derivative, options contracts act as an insurance policy on any losses related to an investment. Investors use options to enjoy the upside of investing in a specific stock and limit potential losses. You can apply this strategy by selling the put options and buying the call options and vice versa. Options are also one of the cheapest ways to hedge your investments.
When trading agricultural products, commercial farmers often use the short hedges vs. long hedges strategy. A short hedge is used to reduce the risk that the farmers have already taken. It locks the price of their product or commodity. With a short hedge, the farmers hedge against an expected downturn in the underlying asset (e.g. grain) price and often pay a premium to maintain a preferred rate of sale.
Long hedges protect against any possible increases in the price of an underlying asset by assuring a future supply with a fixed maximum price. The advantage for a seller is locking in a minimum price.
Another way of hedging for farmers is future contracts. As a rule, they are more liquid than the forward contracts and move with the market. By selling future contracts the farmer can reduce the risk that they will face in the future.
Contracts for Difference
Contracts for difference (CFDs) imply that the seller will pay the buyer any difference in price between the value of an asset at the time the contract was signed and the current value of that asset. In the case of a negative difference, the buyer will pay the seller. CFDs can be effectively used as a hedging strategy. For example, a trader holding shares may open a short term CFD to hedge against longer-term exposure in those shares. Therefore, if the price of the shares becomes lower, the investor will not incur a loss because the CFD hedge will cover that loss.
Forex traders can establish a hedge position by using two different currency pairs that have either a positive correlation or a negative relationship. Being aware of this price relationship can help mitigate any risks.
For example, EUR/GBP has an 84% negative correlation with GBP/JPY. In this case, you can go long EUR/GBP and short GBP/JPY to hedge your GBP exposure. However, at the same time, you become exposed to the exchange rate fluctuations in the EUR and JPY.
Gold can help investors secure themselves against inflation of the US dollar. There is an inverse correlation between gold prices and the US dollar. If gold prices go up, the US dollar goes down and vice versa.
Oil price can influence some currencies, especially the Canadian dollar, because of a positive correlation between its exchange rate and the oil price. When the oil price goes up, the USD/CAD exchange rate weakens. In this case, the oil hedging strategy can be used to hedge the investor’s exposure to the USD/CAD trade by going long USD/CAD and going short on oil.
Other Hedging Strategies
There are also strategies that are not tied to any commodities, such as:
- Price fixing: Benefiting from the current favorable market levels for future physical transactions.
- Averaging: Settling average transactions against average prices observed over a specific time period instead of hedging against a single price fixed on a single date.
- Arbitrage: Taking opposite positions on two markets to hedge physical pricing on different markets for the same or similar products.
A hedge is a strategy used to protect the assets against losses, acting as an insurance policy. The predecessor of the modern hedging concept is the “commitment”, which was invented by Chicago farmers around 1848. Commitment agreements between the farmers and dealers resulted in the creation of the Chicago Board of Trade. Alfred Winslow Jones, a reporter at Forbes, coined the “hedge fund” term in 1949.
It is possible to use various assets as a hedging tool, such as agricultural commodities, options, CFDs, currency pairs, gold, and oil. Other examples of hedging strategies are price fixing, averaging, and arbitrage.
The main drawback of hedging is that it is not free of charge. Whereas an insurance policy guarantees complete compensation of a loss minus a deductible, hedging does not give such a guarantee. However, risk managers are always aiming for the perfect hedge that will eliminate all market risks from a portfolio.