“Hedge your bets” is a phrase most people are familiar with. It means to be prepared for and protect yourself from a bad outcome. Hedging is a strategy some investors may use in an effort to protect themselves from things that could potentially go wrong with an investment. It can reduce the risk of falling prices or rising costs, which can impact an investor’s returns.
What is hedging and why do investors do it?
Hedging is the practice of buying one investment to offset another investment’s risk. It allows investors to protect against specific risks of a particular market, portfolio, or asset type–including stocks, bonds, and commodities. The type of hedging used depends on what an investor wants to protect.
Hedging may help investors avoid or control losses from price volatility. It can also help them manage short-term risks, which last weeks or months, not years, and can give more certainty and stability to the value of their investments.
While hedging may limit risk and protect against the downside, investors forego potential profit opportunities when they hedge. Hedges are also difficult to construct, since investments and their risks evolve over time. The hedge strategy or instrument may not align completely with the investment being hedged. For example, a $500,000 diversified stock portfolio might only be covered by $400,000 in stock index futures.
The difference between hedging and speculation
Hedging is an action to try to avoid risk or minimize losses. Speculation is one that accepts risk. They are two sides of the same risk coin: hedgers buy protection against certain risks; a speculator sells the protection to the hedger.
Types of risk investors may want to hedge
Investors can face different risks, depending on the types of investments they hold. Those risks include:
- Market risk. Also called systematic risk, this refers to the possibility of losses in all markets stemming from macroeconomic or geopolitical events–recessions, increases in central bank interest rates, or wars, for example. Market risk can be reduced through diversification, but not eliminated.
- Interest-rate risk. This mostly pertains to bond markets. Changes in prevailing interest rates, or yields, affect the market price of bonds inversely: rising rates result in lower bond prices.
- Equity risk. This is the risk of stock prices falling—or for short sellers who bet on falling prices, rising.
- Currency risk. The risk that an investment denominated in another country’s currency will suffer from a declining exchange rate for the currency. Investors holding foreign assets need to be aware of currency risk.
- Inflation risk. Inflation diminishes the purchasing power of fixed income generated by an investment, such as bond interest. As such, bonds and other investments with fixed rates are most vulnerable to this risk. As an example, if a bond pays a 4% interest rate, and the rate of inflation is 3%, the bond is returning only 1% to the investor, adjusted for inflation.
Common hedging strategies
The idea behind hedging is to reduce the risk of falling prices or rising costs. For a particular investment or asset type, this can be done using another investment that counters the risk of the first investment. There are two basic forms of hedging: Structured hedges and natural hedges.
A structured hedge is created by using a derivative to offset the risk of the primary investment or asset. Derivatives such as options, futures, and swap agreements are typically used. These are examples of forward agreements, and hedges using them are forward hedges, because they are directed forward in time to the expiration of the derivative.
- Options. Options give an investor the right to sell the asset at a set price. They are commonly used to hedge stocks, commodities, and currencies. A put option, for example, allows an investor to sell stock at a particular price, setting a floor price so an investor doesn’t lose more than a predetermined amount if the stock price falls. For example, if XYZ Corp. trades at $100 a share, and an investor is worried about the share price slumping, they can buy a put option for $5 a share, giving him the right to sell XYZ for $95. One negative of options is that they cost money, usually several dollars a share for stock options, which can eat into any gains. Using options may also require an investor to commit to a broker’s minimum capital and margin requirements.
- Futures. Futures are contracts that obligate an investor to buy or sell a predetermined amount of an asset at a predetermined price, at some future time. They are commonly used to hedge stocks, indexes, commodities, currencies, and bonds. Bond investors might hedge by borrowing exchange-traded Treasury bond futures on margin from a broker and selling them short, if they fear rising interest rates or inflation will cause bond losses. Commodity futures are also used to hedge against price volatility. An oil producer might sell crude oil futures for $100 a barrel, in case the spot market price of crude declines, while a refiner of crude might buy $100 crude futures, in case spot prices increase. Using futures, like options, may also require an investor to commit to broker’s minimum capital and margin requirements.
- Swaps. Swaps are over-the-counter agreements to exchange, or swap, periodic cash flows such as bond interest payments. They may be used by currency investors to manage fluctuating exchange rates by exchanging interest from bonds in two different currencies such as the dollar and euro. Bond investors can also arrange hedges such as interest-rate swaps. For example, an investor expecting higher interest rates might swap by paying a fixed rate on a notional amount of principal and receiving a floating or variable rate, which rises when interest rates rise.
A natural hedge is attained by owning an array of investments that are naturally uncorrelated. It does not involve the use of a derivative. This is known as portfolio diversification—the investments don’t rise or fall together, in the same direction or to the same degree. One asset’s gain may compensate for another asset’s loss.
For example, stocks and bonds are naturally uncorrelated, since those two markets generally don’t rise together. Other examples of low-correlation pairs are stocks and real estate, or U.S. stocks and emerging-market stocks.
Purchasing gold is commonly regarded as an inflation hedge. Inflation-protected or inflation-indexed bonds are also hedges against inflation. These are sold by the U.S. and many other governments and protect against inflation. Their value increases periodically in line with the country’s consumer-price index.
Frequently asked questions about hedging
Do hedge funds offer investors a hedge?
Possibly, but not always. Hedge funds are investment funds that collect money from wealthy individuals and institutions. Despite their name, hedge funds typically seek riskier, profit-maximizing strategies rather than conservative loss-protection strategies. This is partly because the typical compensation plan for hedge fund managers gives them more incentive to take risks, not minimize risks.
What is a perfect hedge?
A perfect hedge would occur when an investor’s hedge position eliminates 100% of the risk of the investment. In other words, the hedge has an exact inverse correlation to the investment. If the investment valued at $1 million declines 5% in value, the hedge position, also valued at $1 million, rises 5%. Perfect hedges are rare, since it’s difficult for an investor to exactly match an investment and a hedge instrument or position.
The bottom line
Hedging can be useful to investors for controlling specific risks, for limited periods of time. Professional fund managers and short-term traders generally use hedging more frequently than small investors. It may be less useful and not cost-effective for long-term investors, who have more time to weather volatility and wait for markets to rebound.