Hedging in Perspective

1. Hedging as a technique
The theory of hedging involves taking an offsetting position when it comes to market related issues
whichinclude offsettingthe probabilityof lossarizing from the fluctuation in currencies, securities and
the prices of commodities.
Hedging involves the use of market instruments, the most common of which are futures, options and
averages.
Thus,hedgingbecome aninvestmenttoreduce the riskof adverse effectof the movement of price and
other related issues.
Most important, hedging is a financial strategy employed to guide against loss of investment or
portfolio.This usuallyinvolvesbuyingsecuritiesthatmove inthe oppositedirectionthanthe assetbeing
protected.
Hedgingisthe practice of purchasing and holding securities specifically to reduce portfolio risk. These
securities are intended to move in a different direction than the remainder of the portfolio - for
example, appreciating when other investments decline. A put option on a stock or index is the classic
hedging instrument.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is
100% inversely correlated to the vulnerable asset.
Whenproperlydone,hedgingsignificantly reduces the uncertainty and the amount of capital at risk in
an investment, without significantly reducing the potential rate of return.
Simple reason for hedging
 To reduce risk exposure.
 To reduce transaction costs.
 For consistent and stable cash flows.
 To determine a sale/purchase price of a commodity/security.
Nature of hedging
Hedgingmaysoundlike acautiousapproach to investing,destinedtoprovide sub-marketreturns, but it
is often the most aggressive investors who hedge. By reducing the risk in one part of a portfolio, an
investorcan oftentake on more riskelsewhere,increasinghisorherabsolute returnswhile putting less
capital at risk in each individual investment.
Hedgingisalsousedto helpensure thatinvestorscanmeetfuture repaymentobligations. For example,
if an investmentismade withborrowedmoney, a hedge should be in place to make sure that the debt

2. can be repaid. Or, if a pension fund has future liabilities, then it is only responsible for hedging the
portfolio against catastrophic loss.
In essence,whenoperating infuturesmarketshedgingimpliestaking a position opposite to that in the
physical market. Hedging is the opposite of speculation - hedgers are NOT trying to "win" and make
moneyonthe price movements.Lockingaprice todayallows forbetterfocus on planning and business
development with minimum exposure to an unwanted business risk. Hedging can vary in complexity
from relatively simple "off-setting trades" through to complex derivative structures.
Hedging islike buyinginsurance.Itisprotectionagainst unforeseen events, but investors usually hope
they never have to use it. Consider why almost everyone buys homeowner's insurance. Because the
oddsof havingone’shouse destroyedare relativelysmall, this may seem like a foolish investment. But
our homes are very valuable to us and we would be devastated by their loss. Using options to hedge
your portfolio essentially does the same thing. Should a stock or portfolio take an unforeseen turn,
holding an option opposite of your position will help to limit your losses.
Portfolio hedging is an important technique to learn. Although the calculations can be complex, most
investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is
especiallyhelpfulwhenaninvestorhasexperiencedanextendedperiodof gains and feels this increase
mightnot be sustainable inthe future.Like all investment strategies, hedging requires a little planning
before executingatrade.However,the securitythatthisstrategyprovidescould make it well worth the
time and effort.
How it work
Hedgingemploysvarioustechniquesbut,basically,involves taking equal and opposite positions in two
different markets (such as cash and futures markets). Hedging is used also in protecting one's capital
againsteffectsof inflationthroughinvestingin high-yield financial instruments (bonds, notes, shares),
real estate, or precious metals.
Hedging in the futures market is a two-step process. Depending upon the hedger's cash market
situation, he will either buy or sell futures as his first position. For instance, if he is going to buy a
commodityinthe cash marketat a latertime,hisfirststepisto buy futurescontracts.Or if he isgoing to
sell a cash commodity at a later time, his first step in the hedging process is to sell futures contracts.
The second step in the process occurs when the cash market transaction takes place. At this time the
futurespositionisnolongerneededforprice protectionand should therefore be offset (closed out). If
the hedgerwasinitiallylong(longhedge),he wouldoffsethispositionbyselling the contract back. If he
was initiallyshort(shorthedge), he would buy back the futures contract. Both the opening and closing
positions must be for the same commodity, number of contracts, and delivery month.

3. Hedging Procedures
Hedging can come through various procedures and this can be through derivative orthrough
diversification.
1. Hedging Through Derivatives
Derivatives are securities that move in terms of one or more underlying assets; they include options,
swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities,
currencies,indicesorinterestrates.Derivativescanbe effective hedgesagainst their underlying assets,
since the relationship between the two is more or less clearly defined.
The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the "hedge
ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the price of the
underlying asset.
2. Hedging Through Diversification
Usingderivativestohedge aninvestmentenablesforprecise calculationsof risk,butrequiresameasure
of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however.
Strategically diversifying a portfolio to reduce certain risks can also be considered a—rather crude—
hedge.Forexample, Johnmightinvest in a luxury goods company with rising margins. He might worry,
though, that a recession could wipe out the market for conspicuous consumption. One way to combat
that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty
dividends.
This strategy has its tradeoffs: if wages are high and jobs are plentiful, the luxury goods maker might
thrive,butfewinvestorswouldbe attractedtoboringcounter-cyclical stocks,whichmight fall as capital
flowstomore excitingplaces.Italsohas its risks: there is no guarantee that the luxury goods stock and
the hedge will move in opposite directions. They could both drop due to one catastrophic event, as
happened during the financial crisis.
Other hedging strategy
1. Averagingisa strategywhereby,insteadof hedgingagainstasingle price fixed on a single date,
average transactions settle against average prices observed over a certain period of time.
2. Offset is a simple offsetting of the physical market exposure.
3. Price Fixing involves taking advantage of the current favourable market levels for the future
physical transactions.
4. Arbitrage involvestakingopposite positions on two markets, in order to hedge physical pricing
on different markets for the same or similar products.

4. Benefit/Cost in hedging
Benefits:
Abilitytomanage the price riskto a necessarydegree,betterplanning,businessdevelopment and more
flexibility with regard to pricing policies.
Costs:
Potentially foregoing any potential profits from market fluctuations, the temporary cash outlay and a
broker's fee.
Conclusion
Hedgingcan be viewedasthe transferof unacceptable riskfrom a portfolio manager to an insurer. This
makesthe processa two-stepapproach.First,determine whatlevelof risk is acceptable. Then, identify
the transactions that can cost effectively transfer this risk.
As a rule, longer term put options with a lower strike price provide the best hedging value. They are
initially expensive, but their cost per market day can be very low, which makes them useful for long-
terminvestments.These long-termputoptionscanbe rolledforward to later expiries and higher strike
prices, ensuring that an appropriate hedge is always in place.
Some investments are much easier to hedge than others. Usually, investments such as broad indexes
are muchcheaperto hedge thanindividualstocks.Lowervolatilitymakesthe put optionslessexpensive,
and a high liquidity makes spread transactions possible.
But while hedgingcanhelpeliminatethe riskof a suddenprice decline,itdoes nothing to prevent long-
term underperformance. It should be considered a complement, rather than a substitute, to other
portfoliomanagementtechniquessuchas diversification, rebalancing and disciplined security analysis
and selection.
References:
1. Hedging by BusinessDictionary.com
2. Hedging by Investopedia.com
3. Hedging by InvestingAnswers.com
4. Hedging by Sucden Financial Limited, Plantation Place South, 60 Great Tower Street , London
5. Hedging by USAFutures: Technical Commodity Futures Markets Research and Trading 10260 SW
Greenburg, Portland, Oregon 97223.
6. Practical And Affordable Hedging Strategies By Tristan Yates via Investopedia.com