In finance, a hedge is a position established in one market in an attempt to offset

exposure to price changes or fluctuations in some opposite position with the goal of
minimizing one's exposure to unwanted risk. There are many specific financial vehicles
to accomplish this, including insurance policies, forward contracts, swaps, options, many
types of over-the-counter and derivative products, and perhaps most popularly, futures
contracts. Public futures markets were established in the 1800s to allow transparent,
standardized, and efficient hedging of agricultural commodity prices; they have since
expanded to include futures contracts for hedging the values of energy, precious metals,
foreign currency, and interest rate fluctuations.

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of wheat and other
crops fluctuate constantly as supply and demand for them vary, with occasional large
moves in either direction. Based on current prices and forecast levels at harvest time, the
farmer might decide that planting wheat is a good idea one season, but the forecast prices
are only that — forecasts. Once the farmer plants wheat, he is committed to it for an
entire growing season. If the actual price of wheat rises greatly between planting and
harvest, the farmer stands to make a lot of unexpected money, but if the actual price
drops by harvest time, he could be ruined.

If the farmer sells a number of wheat futures contracts equivalent to his crop size at
planting time, he effectively locks in the price of wheat at that time: the contract is an
agreement to deliver a certain number of bushels of wheat to a specified place on a
certain date in the future for a certain fixed price. The farmer has hedged his exposure to
wheat prices; he no longer cares whether the current price rises or falls, because he is
guaranteed a price by the contract. He no longer needs to worry about being ruined by a
low wheat price at harvest time, but he also gives up the chance at making extra money
from a high wheat price at harvest times.

[edit] Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month,
due to the company's new and efficient method of producing widgets. He wants to buy
Company A shares to profit from their expected price increase. But Company A is part of
the highly volatile widget industry. If the trader simply bought the shares based on his
belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge
out the industry risk by short selling an equal value (number of shares × price) of the
shares of Company A's direct competitor, Company B.

The first day the trader's portfolio is:

• Long 1,000 shares of Company A at $1 each

• Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares)

If the trader was able to short sell an asset whose price had a mathematically defined
relation with Company A's stock price (for example a call option on Company A shares),
the trade might be essentially riskless. But in this case, the risk is lessened but not
removed.

On the second day, a favorable news story about the widgets industry is published and the
value of all widgets stock goes up. Company A, however, because it is a stronger
company, increases by 10%, while Company B increases by just 5%:

• Long 1,000 shares of Company A at $1.10 each: $100 gain

• Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the
Company A position. But on the third day, an unfavorable news story is published about
the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of
the widgets industry in the course of a few hours. Nevertheless, since Company A is the
better company, it suffers less than Company B:

Value of long position (Company A):

• Day 1: $1,000
• Day 2: $1,100
• Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):

• Day 1: −$1,000
• Day 2: −$1,050
• Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000
he has used in short selling Company B's shares to buy Company A's shares as well). But
the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25
during a dramatic market collapse.

[edit] Hedging fuel consumption

Main article: Fuel hedging

Airlines use futures contracts and derivatives to hedge their exposure to the price of jet
fuel. They know that they must purchase jet fuel for as long as they want to stay in
business, and fuel prices are notoriously volatile. By using crude oil futures contracts to
hedge their fuel requirements (and engaging in similar but more complex derivatives
transactions), Southwest Airlines was able to save a large amount of money when buying
fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the
2003 Iraq war and Hurricane Katrina.

[edit] Types of hedging

The stock example above is a "classic" sort of hedge, known in the industry as a pairs
trade due to the trading on a pair of related securities. As investors became more
sophisticated, along with the mathematical tools used to calculate values (known as
models), the types of hedges have increased greatly.

[edit] Hedging strategies

Examples of hedging include:

• Forward exchange contract for currencies

• Currency future contracts
• Money Market Operations for currencies
• Forward Exchange Contract for interest (FRA)
• Money Market Operations for interest
• Future contracts for interest

This is a list of hedging strategies, grouped by category.

[edit] Financial derivatives such as call and put options

• Risk reversal: Simultaneously buying a call option and selling a put option. This
has the effect of simulating being long a stock or commodity position.
• Delta neutral: This is a market neutral position that allows a portfolio to maintain
a positive cash flow by dynamically re-hedging to maintain a market neutral
position. This is also a type of market neutral strategy.

[edit] Natural hedges

Many hedges do not involve exotic financial instruments or derivatives such as the
married put. A natural hedge is an investment that reduces the undesired risk by matching
cash flows (i.e. revenues and expenses). For example, an exporter to the United States
faces a risk of changes in the value of the U.S. dollar and chooses to open a production
facility in that market to match its expected sales revenue to its cost structure. Another
example is a company that opens a subsidiary in another country and borrows in the
foreign currency to finance its operations, even though the foreign interest rate may be
more expensive than in its home country: by matching the debt payments to expected
revenues in the foreign currency, the parent company has reduced its foreign currency
exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars,
but faces costs in a different currency; it would be applying a natural hedge if it agreed to,
for example, pay bonuses to employees in U.S. dollars.

One common means of hedging against risk is the purchase of insurance to protect
against financial loss due to accidental property damage or loss, personal injury, or loss
of life.

[edit] Categories of hedgeable risk

There are varying types of risk that can be protected against with a hedge. Those types of
risks include:

• Commodity risk: the risk that arises from potential movements in the value of
commodity contracts, which include agricultural products, metals, and energy
products.[1]

• Credit risk: the risk that money owing will not be paid by an obligor. Since credit
risk is the natural business of banks, but an unwanted risk for commercial traders,
an early market developed between banks and traders that involved selling
obligations at a discounted rate.

• Currency risk (also known as Foreign Exchange Risk hedging) is used both by
financial investors to deflect the risks they encounter when investing abroad and
by non-financial actors in the global economy for whom multi-currency activities
are a necessary evil rather than a desired state of exposure.

• Interest rate risk: the risk that the relative value of an interest-bearing liability,
such as a loan or a bond, will worsen due to an interest rate increase. Interest rate
risks can be hedged using fixed-income instruments or interest rate swaps.

• Equity risk: the risk that one's investments will depreciate because of stock
market dynamics causing one to lose money.

• Volatility risk: is the threat that an exchange rate movement poses to an investor's
portfolio in a foreign currency.

• Volumetric risk: the risk that a customer demands more or less of a product that
expected.

[edit] Hedging equity and equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect
your stock picking against systematic market risk, futures are shorted when equity is
purchased, or long futures when stock is shorted.
One way to hedge is the market neutral approach. In this approach, an equivalent dollar
amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth
of Vodafone and shorting 10,000 worth of FTSE futures.

Another way to hedge is the beta neutral. Beta is the historical correlation between a
stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long
position in Vodafone an investor would hedge with a 20,000 GBP equivalent short
position in the FTSE futures (the index in which Vodafone trades).

Futures contracts and forward contracts are means of hedging against the risk of adverse
market movements. These originally developed out of commodity markets in the 19th
century, but over the last fifty years a large global market developed in products to hedge
financial market risk.

[edit] Futures hedging

Investors who primarily trade in futures may hedge their futures against synthetic futures.
A synthetic in this case is a synthetic future comprising a call and a put position. Long
synthetic futures means long call and short put at the same expiry price. To hedge against
a long futures trade a short position in synthetics can be established, and vice versa.

[edit] Contract for difference

Main article: Contract for difference

A contract for difference (CFD) is a two-way hedge or swap contract that allows the
seller and purchaser to fix the price of a volatile commodity. Consider a deal between an
electricity producer and an electricity retailer, both of whom trade through an electricity
market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1
MWh in a trading period, and if the actual pool price is $70, then the producer gets $70
from the pool but has to rebate $20 (the "difference" between the strike price and the pool
price) to the retailer. Conversely, the retailer pays the difference to the producer if the
pool price is lower than the agreed upon contractual strike price. In effect, the pool
volatility is nullified and the parties pay and receive $50 per MWh. However, the party
who pays the difference is "out of the money" because without the hedge they would
have received the benefit of the pool price.

[edit] Related concepts

• Forwards: A contracted agreement specifying an amount of currency to be
delivered, at an exchange rate decided on the date of contract.
• Forward Rate Agreement (FRA): A contract agreement specifying an interest rate
amount to be settled at a pre-determined interest rate on the date of the contract.
• Currency option: A contract that gives the owner the right, but not the obligation,
to take (call option) or deliver (put option) a specified amount of currency, at an
exchange rate decided at the date of purchase.
• Non-Deliverable Forwards (NDF): A strictly risk-transfer financial product
similar to a Forward Rate Agreement, but used only where monetary policy
restrictions on the currency in question limit the free flow and conversion of
capital. As the name suggests, NDFs are not delivered but settled in a reference
currency, usually USD or EUR, where the parties exchange the gain or loss that
the NDF instrument yields, and if the buyer of the controlled currency truly needs
that hard currency, he can take the reference payout and go to the government in
question and convert the USD or EUR payout. The insurance effect is the same;
it's just that the supply of insured currency is restricted and controlled by
government. See Capital Control.
• Interest rate parity and Covered interest arbitrage: The simple concept that two
similar investments in two different currencies ought to yield the same return. If
the two similar investments are not at face value offering the same interest rate
return, the difference should conceptually be made up by changes in the exchange
rate over the life of the investment. IRP basically provides the math to calculate a
projected or implied forward rate of exchange. This calculated rate is not and
cannot be considered a prediction or forecast, but rather is the arbitrage-free
calculation for what the exchange rate is implied to be in order for it to be
impossible to make a free profit by converting money to one currency, investing it
for a period, then converting back and making more money than if a person had
invested in the same opportunity in the original currency.
• Hedge fund: A fund which may engage in hedged transactions or hedged
investment strategies.