Hedging

The dictionary definition of "hedge" is as follows:

To protect oneself financially:

a) to buy or sell commodity futures as a protection against loss due to price fluctuation
b) to minimize the risk of a bet

(Source: Merriam-Webster dictionary)

Though the dictionary definition is simple, it doesn't really tell us much about the concept of "hedging" in financial economics. There isn't really much to it. However, I have encountered people who were pretty amused upon hearing my explanation and thought some readers might find this information interesting too.

---

A SIMPLE EXAMPLE

I can think of a primitive example to illustrate hedging:

Suppose you bought 100 shares of a company today and the price of the share rose by $1. This net you a total profit of $100, if you choose to sell the shares now.

What if for some reason you do not wish to realise the $100 in capital gains until a later date? (Perhaps due to taxation) However, if you continue to hold onto the 100 shares, you risk losing the $100 profit due to a future fall in price.

So what can you do to keep the $100 profit unrealised but safe from future price movements?

A simple way is to sell 100 shares of the same company at the current price, while still holding onto the original 100 shares. This can be done through a separate brokerage account but is generally allowed within the same account.

A $1 movement in the long position (original 100 shares) in any direction will be matched by a $1 movement in the short position (sale of another 100 shares) in the opposite direction. Hence, any future losses or gain experienced by the original 100 shares is perfectly nullified by the short sale of 100 shares. The $100 profit remains no matter what happens to the price of the share.

The portfolio is thus hedged.

---

APPLICATIONS

The basic principle of hedging can be applied to many other situations.

For example, suppose you buy an investment denominated in foreign currency and hold it for one year. Thus, in one year's time you will receive two components:

1) The return on the investment
2) Profit/loss due to currency exchange rate changes

If your investment goal is solely to earn the returns on the investment and want to avoid currency risk, you can hedge the currency risk using the same mechanics outlined before.

For example, the currency risk component of using US dollars (USD) to buy a Japanese Yen denominated asset for one year is the same as having a short position on USD/Yen for one year. To hedge, we simply buy an equivalent amount of USD/Yen to create a long position. Any profits or losses made in the short position is offset by those of the long position. This leaves the portfolio perfectly hedge against currency risk.

The possibilities are endless...