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Introduction to Finance/Risk Mitigation/What Is Hedging?

Risk Mitigation

Contents

What Is Hedging?

Definition of Hedging

To minimize risk and achieve higher returns, some investors use hedging strategies which can be short- or long-term in nature.

Hedging is an investment strategy that attempts to lower the risk of unexpected events. It is appropriate to view hedging as a form of insurance. Like insurance, hedging does not prevent potential adverse events from occurring; rather, it reduces the negative impacts of those events should they occur. A natural hedge is the phenomenon of two assets with opposite risk profiles that cancel out each other's risk. These assets may be a combination of any of the following: currencies, stocks, bonds, and commodities. The only requirement for a natural hedge is that the assets' risks are negatively correlated to each other.

For example, if an investor chooses to purchase high-yield bonds, or junk bonds, these carry a very high risk of default which increases risk exposure within an investment portfolio. Thus, the investor will use alternative investments such as stocks or bonds that have a low risk measure, or low beta value, that offsets overall risk exposure. As a result, this will minimize risk exposure that the portfolio will realize if the junk bonds default so the investor will not realize extremely high material losses.

There are two basic hedging strategies: long hedge and short hedge. The purchasing and selling of seasonal commodities often involves long hedging and short hedging strategies. A long hedge is an investment strategy that secures the price of an asset in anticipation that the asset's price will increase in the future. Firms that will require an asset in the future but wish to protect themselves from the possibility of paying inflated prices utilize long hedges. Where "holding long" indicates the purchase of an asset, a short hedge is an investment strategy that secures the price in anticipation of the price or value of an asset diminishing. Firms that would need to sell an asset in the future but prefer protection from the possibility of price decreases utilize short hedges.

For example, Big Box makes a futures contract with Tomato King to purchase tomatoes at a pre-established price for the upcoming winter season. Here, Big Box is making a long hedge. Big Box has secured the tomatoes at a specific price in anticipation of the price increasing in the future when tomatoes are out of season. Tomato King, on the other hand, has performed a short hedge. Tomato King has sold the future tomatoes at a specific price in advance in anticipation that the price will decrease in the future. Tomato King believes the winter season will be mild and there will be a tomato surplus this winter.

Fundamentals of Hedging

Investors use hedging strategies to insure their investments against market fluctuations.
In another example, an investor believes that the share price of Big Box is undervalued and has growth potential. However, this investor wishes to mitigate potential losses in case of a market downturn. To accomplish this, the investor will use a short hedge strategy by short selling. Short selling is borrowing and then selling a security with the expectation that the price will decline. A short seller profits if a security's price declines. The investor has also researched another store, Super Center, and believes that the company is overvalued. The investor believes that the short sale of Super Center shares will be negatively correlated to the purchased shares of Big Box. If the market were to decline and Big Box shares lose value, the investor's losses would be offset by the short sale of Super Center stock. The investor is therefore unharmed. The investment strategy that results in equal gains and losses is called a perfect hedge. The investor short sells 800 shares of Super Center at $125 per share and receives $100,000. Short selling is the sale of a security that the seller has borrowed or when a seller borrows shares of a stock on the premise that the share price will drop. A short seller profits if a security’s price declines. In other words, the trader sells to open the position and expects to buy it back later at a lower price and will keep the difference as a gain. However, if the price of the shares does not decrease, then there is a loss on the transaction and the short seller must return those shares and cover the loss from their own accounts.
$125per Share×800Shares=$100,000\$125\;{\text{per Share}}\times800\;{\text{Shares}}=\$100{,}000
The investor uses the $100,000 to purchase 1,000 shares of Big Box at $100 per share.
$100per Share×1,000Shares=$100,000\$100\;{\text{per Share}}\times1{,}000\;{\text{Shares}}=\$100{,}000
Unfortunately, the market declines. Accordingly, Big Box's and Super Center's share values decline to $80 per share and $100 per share, respectively. The value of the investor's Big Box shares is now $80,000.
$80per Share×1,000Shares=$80,000\$80\;{\text{per Share}}\times1{,}000\;{\text{Shares}}=\$80{,}000
This makes the Big Box investment a loss of $20,000 or $100,000−$80,000=$20,000\$100{,}000-\$80{,}000=\$20{,}000. However, the investor is unharmed because of the short hedge of Super Center. The new value of Super Center is $80,000.
$100per Share×800Shares=$80,000\$100\;{\text{per Share}}\times800\;{\text{Shares}}=\$80{,}000
Therefore, the investor gains $20,000 on the short sale of Super Center and pulled off a perfect hedge.
$100,000−$80,000=$20,000\$100{,}000-\$80{,}000=\$20{,}000

Overview of the Hedge Fund Process

Generally, hedge funds are pooled funds from multiple large investors to generate revenue from beta movement.
A hedge fund is a limited partnership formed by a small group of investors who combine capital to invest in assets in order to maximize gains while mitigating risk. The investors in the hedge fund seek to generate revenue from beta (β\beta) movement. Beta is the amount of systematic risk an asset or portfolio has with respect to the market. Systematic risk is the volatility that affects assets on a macroeconomic scale. Hedge fund investors expect to realize gains regardless of whether the market is up or down. Hedge fund managers may accomplish this by using long hedge and/or short hedge strategies. The hedge fund manager makes all executive decisions regarding the operation and overall strategy of the fund.

Hedged versus Nonhedged Strategy

Hedge fund strategies attempt to cover potential losses or even make gains for all market scenarios.
Hedge funds receive less regulatory government oversight from the Securities and Exchange Commission (SEC) than traditional investments. For this reason, hedge funds are more exclusive when selecting investors and are able to choose from a wide variety of investment options. Accordingly, investing in hedge funds is restricted to experienced, wealthy investors. These investors must have a net worth over $1 million or have an annual income exceeding $200,000 for the last two years, and they must reasonably expect to earn the same income for the current year. Investment assets for hedge funds may be made up of a wide variety of assets, such as stocks, real estate, bonds, currency, and derivatives.

Hedge funds typically have a fee structure commonly referred to as "2 and 20." This refers to a management fee of 2 percent of the asset portfolio and an incentive fee of 20 percent for any gains realized. The 2 percent management fee is a flat fee that the hedge fund managers receive regardless of the hedge fund's performance. This fee may be compared to a salary. The incentive fee is a motivation for hedge fund managers to maximize investor gains. The 2 and 20 structure is common, but certain experienced hedge fund managers may negotiate more lucrative fee structures.

Various Hedge Fund Methods

Many forms of hedging, such as equity hedge, market neutral strategy, distressed debt hedge, global macro hedge, and merger arbitrage, use put options and sell a stock short with cover.

There are various hedge fund methods, including equity hedge, market neutral strategy, distressed debt hedge strategy, global macro hedge, and merger arbitrage strategy. Many of these methods use put options with cover. A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame. Cover is the buyback action of the put option. An equity hedge is a strategy used by managers to control the investment's exposure to the equity market. The manager selects a stock that is undervalued and has growth potential and a stock that is overvalued and is expected to correct, meaning it will return to its actual lesser value. A portion of the assets will be invested in a growth stock, and the remaining portion will be invested in short hedge positions. The manager controls the long/short hedge fund ratio based on the desired level of exposure. For example, Money Company LLC holds stock in Cogs Inc. that currently sells for $100 per share. Money Company believes that the stock price will increase significantly, so it enters into a put option contract on the stock for $125. Mary Nelson buys the option for $5 per share. If the stock rises to $135, Mary can sell the stock on the market for $125 and make a $10 profit. If it does not, Mary will not sell the stock and will lose $15 per share at the time of option expiration ($5+$135=$140−$125=$15\$5\;+\$135=\$140-\$125\;=\$15)

Money Company will make a profit either way. If the option is not exercised, the company will still make $5 per share. Equity hedging is the most-used method for new hedge funds.

A market neutral strategy is a strategy that secures an equal portion of assets in long and short positions, making the market exposure equal to zero. This, in theory, is a perfect hedge. A distressed debt hedge strategy is the purchase of a troubled company's devalued debt with the expectation that the company will recover. Debt is devalued when the real value of the debt declines because the value of the dollar declines. The hedge fund manager purchases devalued bonds of a company, usually with insecure finances, and then works with the company to make strategic plans for the company's recovery. This strategy has high risk and high return potential, depending on the level of discount on debt.

A global macro hedge is an investment tactic that is based on making predictions on the growth or decay of a particular nation's economy. Global macro investments may be in stock, debt, currency, real estate, or any other asset within the nation's economy. This strategy presents the most risk and return potential. A merger arbitrage strategy is a tactic that capitalizes on acquisitions, liquidations, and mergers. Normally, when a merger is revealed, the object company's stock price rises and the purchasing company's stock price falls. Hedge fund managers take opposite positions in advance of and following the merger to capitalize on the market's reaction.

<Vocabulary>Diversification with Portfolios