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Hedge (finance)

From Academic Kids

There are other meanings of the word hedge.


In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. The term is a shortened form of "hedging your bets", a gambling term. Typical hedgers purchase a security that the investor thinks will increase in value, and combine this with a "short sell" of a related security or securities in case the market as a whole goes down in value.

Contents

Example hedge

The practice can be illustrated with an example. An investor believes that the company FOO is going to do well this month, and wishes to buy some shares of stock so as to profit from their rise in value. FOO is, however, part of the widgets industry, a sector whose share prices are highly volatile.

Our investor is interested in the company itself, not the vagaries of the industry, and so seeks to hedge out the risk by selling short an equal amount of the shares of FOO's direct competitor, BAR.

On day one, our investor's portfolio looks like this:

  • Long 1000 shares of FOO at 1 USD each
  • Short 500 shares of BAR at 2 USD each

(Notice that the investor has sold short the same value of shares, not the same number; this is important).

On day two, there is a big news story about the widgets industry and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:

  • Long 1000 shares of FOO at 1.10 USD each — 100 USD profit
  • Short 500 shares of BAR at 2.10 USD each — 50 USD loss

(Remember that in a short position, the investor loses money when the price goes up)

Perhaps our investor is regretting the hedge on day two, because it has cut into the profits on the FOO position, but on day three there is another news story that is bad for widgets, and all widgets stock goes down.

This time it's a real crash — 50% is wiped off the value of the widgets industry in the course of a few hours. Once again, however, because FOO is the better company it suffers less than BAR:

Value of long position:

  • Day 1 — 1000 USD
  • Day 2 — 1100 USD
  • Day 3 — 550 USD

Value of short position:

  • Day 1 — 1000 USD
  • Day 2 — 1050 USD
  • Day 3 — 505 USD

Without the hedge, our investor would be looking at a loss of 450 USD. With the hedge, that loss still stands on the long side, but the short side is in profit of 495 USD. That means our investor in widgets is still 45 USD in profit on a day when the market suffered a dramatic collapse.

Types of hedging

The 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. In general, however, all hedge strategies look for a "spread" between market value and real value, and attempt to extract profits when the values converge.

Merger Arbitrage

Another of the classic hedge strategies is to buy the stock of a company that is being taken over in a merger, while shorting the stock of the company that is buying them. In this case the details of the merger are known in advance, for instance company A may offer 10 shares of their own stock for every 8 of company B, which they are purchasing. Given the current market values, the dollar amounts of the takeover bid can be calculated, and the spread between current value and the announced takeover value can be calculated. If the current stock price is below the takeover value, the deal is said to be "in the money".

The hedge in this case is to remove the risk that the takeover will fail. For instance if company B rejects the takeover bid, their stock price will typically fall to its original value, or lower. The same however is also true of company A, whose perceived value will drop as a result of failing in their venture. Therefore the hedging opportunity is to purchase shares of company B (if it is in the money), and short the shares of company A. This way some profit will be made in either case, with the spread disappearing and creating a profit on the long position, while in the case of the deal breaking down the losses on the long position will be hedged out by the gains on the short when the shares of company A fall.

Convertible bond Arbitrage

A convertible bond is type of bond that can optionally be converted into shares of the issuing company at some pre-announced ratio. For instance if the bond has a face value of 1000 dollars and the stock is current trading at $10, a particular bond issue might offer 100 shares of the company at some future date, the so-called "maturity date". In general, this is in the company's favour, if the stock price drops they can offer the shares at a lower total value than the face value of the bond. However, if the stock price increases they can instead simply give you your $1000 back.

Although it might not be obvious, this security also offers a built-in spread. If you buy the bond and short the stock, you will make a profit no matter what happens. For instance if the value of the stock drops the company will give you shares of a lower total value than the $1000 you paid for them, so you lose money. However at the same time you have shorted their stock, so you will make a profit as the stock price falls. On the flip side, if the stock price rises the short position will lose money, but the value of the bond rises as well.

Depository Receipts

A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a Chinese company wishing to raise more money may issue a depository receipt on the New York Stock Exchange, as the amount of capital on the local exchanges is limited. These securities, known as ADRs or GDRs depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. However, they are exchangeable into the original security (known as fungibility) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it you can hedge that risk.

Contract for Differences

A Contract for Differences (CfD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. An example would be a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If the producer and the retailer agree a strike price of, say $50 per MWh, for 1 MWh in a trading period, then if the actual pool price is $70, then the producer get $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. On the other hand the retailer pays the difference to the producer if the pool price is lower than the 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.

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