Hedging

Hedging

• Somewhat analogous to taking out an insurance policy
• In the case of insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible. 
• Unlikely, in the investment space, hedging is both more complex and an imperfect science.
• Definition
• An investment that is made with the intention of reducing the risk of adverse price movements in an asset.
• Hedge by derivatives
• The best way is to make another investment in a targeted and controlled way. 
• Popular hedging techniques involve taking offsetting positions in derivatives that correspond to an existing position.
• The most common way of hedging in the investment world is through derivatives. 
• Derivatives are securities that move in correspondence to one or more underlying assets. 
• They include options, swaps, futures and forward contracts. 
• The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates.
• For example, 
• if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by buying an American put option with a strike price of $8 expiring in one year. 
• This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. 
• Let's assume he pays $1 for the option, or $100 in premium. If one year later STOCK is trading at $12, Morty will not exercise the option and will be out $100. 
• He's unlikely to fret, though, since his unrealized gain is $100 ($100 including the price of the put). 
• If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $300 ($300 including the price of the put). 
• Without the option, he stood to lose his entire investment.
• Hedge by diversification
• Other types of hedges can be constructed via other means like diversification. 
• Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. 
• For example, Rachel might invest in a luxury goods company with rising margins. She 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.
• Delta (Hedge ratio)
• 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 movement in the price of the underlying asset.
• e.g., if a stock option has a delta value of 0.65, this means that if the underlying stock increases in price by $1 per share, the option on it will rise by $0.65 per share, all else being equal.