What Is Hedging | Seeking Alpha

What Is Risk?

In a financial setting, risk, or more specifically holding risk, is a position that implies the potential to suffer financial losses. Risk is not limited to just investing or business, but also everyday financial decisions.

In the world of investing and asset pricing, risk is inherently linked to potential return. Investors may be familiar with the term risk-reward, which is an assessment of how much a financial position could benefit as compared to the amount of risk carried by holding that position.

Owning a Certificate of Deposit or government Treasury Bill, for example, is a very low-risk proposition; there’s very little probability that an investor wouldn’t get their money back along with the investment return they were promised. But accompanying that lower risk are lower expected returns. An investor or business that is willing to accept low returns by keeping risk to a minimum could be referred to as risk averse.

Contrarily, someone who is risk tolerant is more comfortable being exposed to risks in order to potentially reap larger gains. The share ownership of a clinical stage biotech company, for example, where the stock could rise to great heights should a novel new therapy prove to be effective, or quite easily go to $0 if it doesn’t, would be a higher risk investment. The potential gains are large, but so is the risk.

The risk averse-risk tolerant spectrum is a vast one; it doesn’t make sense to classify everyone as one of these two labels. Most investors in the stock market are willing to accept at least a moderate amount of risk in pursuit of additional return.

Key Point: Investors don’t need to be classified as either risk averse or risk tolerant. These 2 labels are simply the opposite ends of the risk spectrum. Most individuals (and businesses) fall somewhere in the middle.

What Is Hedging?

Hedging is a mechanism whereby a given risk exposure is either eliminated or minimized through taking an offsetting position. There are essentially 2 ways to pursue low risk: never taking on risky prospects in the first place, or hedging to mitigate risk exposures that one holds.

Important: It’s important to distinguish the practice of hedging, from hedge funds, the latter which is a name given to privately managed investment funds for accredited investors. While hedge funds may sometimes engage in hedging (such as a long-short fund would), most hedge funds take on high levels of risk. In any case, hedging and hedge funds are in no way synonymous or even closely related.

Hedging can, in many ways, be compared to insurance. For example, if a family buys a house near a river that may flood during the Spring melt, they’re exposed to a quite a risk on a very valuable asset. If the family purchases flood insurance for their home, that risk is mitigated.

In the above example, risk was hedged at the cost of the insurance premium. More commonly, related to financial markets at least, risk is reduced by taking offsetting positions.

Who Can Use Hedging?

People hedge risk all the time. A construction company can use earthquake-resistance technologies to hedge safety risk; a homeowner can install an alarm system to hedge burglary risk; a winning hockey team can place their most defensive players on the ice for the critical last few minutes of a game they are already winning.

Regarding financial risks, both individual investors and companies often adopt strategies to hedge risk. Hedging can involve neutralizing individual asset risks, or managing risk on a portfolio of assets.

Hedging Examples

Investor Example:

Consider an investor who holds large long-term positions in several REITs that they think will outperform, but they are worried that a spike in interest rates could cause the values of these assets to drop in the near-term. The investor could hedge this near-term risk by Shorting a broad real-estate ETF such as VNQ. Another option would be to buy Put Options on this ETF, or a similar one.

Business Examples:

Consider a food products manufacturer who purchases large amounts of corn as a key ingredient into cereals, tortilla chips etc. If company management is concerned about rising input prices, they could purchase futures contracts on corn, so to lock-in their future purchase price of corn instead of being exposed to risk that the price changes.

As a separate example, consider a U.S. gold prospecting company who has just entered into an contractual agreement to sell one of their gold projects in Australia for AUD 150 million (Australian Dollars), to be received two months later when the deal formally closes. Furthermore the plan is to pay the value of the sale as a special dividend to U.S. shareholders. In the interim, the selling company is exposed to currency risk, which could result in losses if the Australian Dollar depreciates in value relative to the U.S. Dollar. To hedge against that risk, the company could sell currency forwards on the AUD.

Important: Investors and companies can choose to hedge a portion of a risk position, instead of all of it, if they’re comfortable with some, but not all, of the risk. Furthermore, in many cases it’s not possible, or unduly difficult or costly, to fully hedge a risk exposure.

Pros And Cons of Hedging

The benefits and costs of applying hedging techniques is relatively straightforward.

Pros:

• Hedging eliminates the risk of loss from negative outcomes, either fully or in part.
• Companies and individuals who hedge risks can approach and prepare for the future with more certainty, if they know they are protected from potential future risk events.

Cons:

• Hedging usually comes at a cost.

1. Sometimes the cost is in the form of a premium paid to insure against risk (such as the cost of an option premium, or insurance).
2. In many cases the cost of hedging is that it limits the potential for profits if markets move in an advantageous direction, instead of a disadvantageous direction.

• Hedge positions are often imperfect. It’s commonly not possible, or unduly difficult or costly, to fully eliminate risk exposure. For example, Shorting a real estate ETF to hedge against a portfolio of individual REIT holdings is imperfect, since the ETF won’t perform exactly the same as those individual stocks.
• Another possible challenge of hedging is when a certain type of risk isn’t easily quantifiable, making it a guessing game of how to appropriately hedge this risk.

Hedging And Risk Management

Risk Management is a term that can be used to describe an entity’s overall approach to risk. Most large companies will have a dedicated Risk Management department that assesses a variety of risks, including:

• Financial Risk
• Legal Risk
• Operational Risk
• Reputational Risk

Risk managers can then decide how to best approach these risks.

Hedging is a solution that can mitigate financial risks through the application of available financial instruments. Corporate risks that are non-financial in nature can often also be hedged in other ways. For example, to hedge the risk of a key technology manager from retiring, a company could contract with a technology consultant who could fill the manager role if needed.

For investors, Portfolio Risk Management relates to the study of one’s investment portfolio for the purpose of planning for possible adverse developments. A key concept for portfolio management is diversification, which is the practice of holding a variety of different types of assets that are expected to react differently in times of market turbulence. Related to diversification, an effective risk management technique is to limit the size of any individual positions.

Beta Hedging And Delta Hedging

Basic hedging is often pursued through the offsetting of notional values. For example, if an investor owns $50,000 of several small-cap stocks, but fears a market downturn, they could attempt to hedge this risk by Shorting $50,000 of SPY, the ETF that tracks the S&P 500. That may not turn out to be a successful strategy if small cap stocks tend to be more volatile than the larger stocks represented by the S&P 500.

Beta hedging would include an assessment of the volatility of the held securities, in the pursuit of hedging Beta value. For example, if the small stocks held in the above portfolio were believed to contain a Beta of 2.0, it might lead to the conclusion that the investor should Short $100,000 of SPY to mitigate against the risk of holding the $50,000 of small-cap stocks.

Delta hedging is similarly an advanced type of hedging that attempts to mitigate risk through (usually) the use of derivatives, which move in a different magnitude as compared to the underlying security. For example, instead of hedging a long currency position of AUD 150 million by selling currency forward contracts, a company might purchase put options on the AUD. If the chosen options have a Delta of 0.75 (read more here), the company would want to purchase AUD 200 million notional of these put options to offset AUD 150 million of currency risk.

Important Note: The Delta of option contacts is not static. The Delta will change over time based on price movements of the underlying security, changes in implied volatility, and also the passage of time. Therefore, Delta Hedging requires regular monitoring and modification of the hedge position.

Bottom Line

Hedging is the practice of offsetting an underlying risk exposure that is subject to possible downside (losses). It can apply to both everyday risks and financial markets risks. While hedging limits or eliminates the downside risk from adverse market developments, doing so also generally has an explicit cost. Notably, most hedges are not perfect, and it is virtually impossible for any individual or entity to eliminate all risks.