A financial hedge is a transaction that reduces the risk of adverse price movements in an existing investment position. It typically involves taking an offsetting position in a related derivative financial instrument. The key derivative instruments are forwards, futures, swaps, and options, and they are commonly used to protect positions in foreign currency, commodities, stocks, and bonds.
For example, the exchange rate risk associated with a foreign currency receivable or payable at a future date can be hedged by entering into a forward contract to buy (payable) or to sell (receivable) at a fixed rate on a specified future date. This locks in a guaranteed value for a future cash flow, irrespective of market fluctuations. An alternative to hedging privately with a bank using an “over-the-counter” (OTC) forward contract is to use an exchange-traded futures contract. For example, if an inflow of currency is expected in the future (an underlying “long” position), then selling futures (going “short”) will ensure that any loss in the spot value of the currency is counteracted by a gain on the short futures position.
Futures contracts may not provide a perfect hedge, either because the underlying asset is different from that underlying the futures contract or because the expiration date of the futures contract does not match the delivery date of the asset or because the standardized value of the futures contracts does not match the value of the underlying exposure. As a result, the spot price of the asset and the futures price will not converge on the expiration date, giving rise to “basis risk.” Although they might not provide a perfect hedge, futures contracts, in contrast to forwards, are tradable and thus allow a hedge to be unwound prior to maturity.
Whereas forwards and futures contracts oblige two parties to make an exchange in the future, and are thus useful to hedge known exposures, an “option contract” gives one party the right, but not the obligation, to buy (a call option) or sell (a put option) an asset, under specified conditions, for a fee (the option “premium”). Options are thus useful to hedge in situations where the exposure is not known with certainty. For example, a company bidding for a foreign competitor may purchase a foreign currency call option to lock in a guaranteed price, in home currency terms, for the transaction, but may let the option expire without exercising it if the deal falls through prior to maturity.
Price risk may also be hedged by means of swap contracts, which involve two parties agreeing to exchange future streams of cash flows according to a prearranged formula. Swaps can be regarded as portfolios of forward contracts, represented by the streams of cash flows, or “legs,” of the swap. These are determined by reference to either interest rates, exchange rates, equity prices, or commodity prices. Although the first swap contracts were only negotiated in 1981, swaps are now the most heavily used derivative product.
Although most financial hedging involves the use of derivative products, it is also possible to construct financial hedges using the “cash” (or “spot”) markets. For example, a company can hedge against the currency risk associated with future payables or receivables by constructing a “money market hedge.” This involves borrowing and investing funds via the money markets and using the spot rate to lock in the amount to be received or paid. A company expecting to receive foreign currency from a client in three months may borrow the present value of the receivable now, discounted at the foreign interest rate, and immediately convert the amount into the home currency at the prevailing spot rate. This money is then invested for three months at the home interest rate. When the foreign currency is received in three months, it is used to pay off, in full, the foreign currency loan. Because no exchange of currency occurs at this point, the future spot rate has no bearing on the outcome. If “interest rate parity” holds—that is, if the difference in interest rates between two currencies is equal, but opposite, to the difference between the spot and forward exchange rates—then a money market hedge would produce the same outcome as a forward market hedge.
Although financial hedges reduce potential losses in the event of adverse price movements, they also incur an opportunity cost if the underlying investment being hedged against makes money. Investors therefore need to make a careful judgment about future market conditions before deciding whether or not to hedge.
- Richard M. Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Wiley, 2007);
- Patrick Cusatis and Martin Thomas, Hedging Instruments and Risk Management: How to Use Derivatives to Control Financial Risk in Any Market (McGraw-Hill, 2005);
- John M. Halstead, Shantaram Hegde and Linda S. Klein, “Hedge Fund Crisis and Financial Contagion: Evidence from Long-Term Capital Management,” Journal of Alternative Investments (v.8/1, 2005)
- Andrew W. Lo, Hedge Funds: An Analytic Perspective (Princeton University Press, 2008);
- Adam Zoia and Aaron Finkel, Getting a Job in Hedge Funds: An Inside Look at How Funds Hire (John Wiley & Sons, 2008).
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