In finance, a hedging transaction is used to alleviate the risk of loss associated with an adverse move in the price of a financial asset. When available, a perfect hedge can fully eliminate the risk of loss. In other cases, the investor can only partially eliminate the risk. Both professional investors as well as amateurs can greatly benefit from hedging transactions.
A hedging transaction is used to eliminate the risk associated with a financial exposure. An investor is said to be exposed to financial risk if she stands to lose money as a result of an adverse move in the financial markets. If you hold a stock or a bond, for example, you can suffer a loss if the price of that security declines. As such, you have an exposure. If, on the other hand, all of your money is sitting in a bank account or is in U.S. government bonds, you have no exposure.
Perfect Hedging Transaction
A perfect hedging transaction locks in a future income stream for the asset you are holding and eliminates all risk resulting from the exposure. A futures contract is an example of a perfect hedge. A futures contract is a legally binding agreement to buy or sell something at a specific price in the future. So if you are holding Ford stock that you bought at $10.50 per share and you take the "sell" side of a futures contract for Ford in six months for $11 per share, you have eliminated all risk and locked in future cash income. Now you are perfectly hedged. In six months, you will be able to sell the shares at $11 apiece, and the other party involved in the futures contract will be obliged to buy them at this price, regardless of the prevailing market prices. As a result, you are protected against a drop in the stock's market price.
An imperfect hedging transaction reduces the probability of loss resulting from an exposure, but it does not eliminate it. In the real world, you can't get a futures contract for every share. Assume you are holding stock issued by a small firm, and it's impossible to lock in a sale price with a futures contract. You can instead short the S&P; 500 index shares to partially hedge your exposure. Shorting S&P; index shares means that the lower the index goes, the more money you will make. So if the price of your stock declines because of a broad decline in stock prices, you will lose money from your exposure to the specific stock you are holding, but you probably will make some money form your short index position. This hedge is imperfect, because your stock and the index might not decline in lockstep. Your stock could lose value even when the index is rising.
Common Hedging Instruments
In addition to futures contracts, options are commonly used to perfectly hedge exposure. An option is basically an optional futures contract. A call option gives you the right, but not the obligation, to buy an asset. A put option allows you to sell an asset if you desire. Swaps are a more exotic swapping choice and are rarely available to the individual investor. A swap is an agreement to exchange payments resulting from one exposure for another. An investor might agree to pay the monthly dollar interest rate, and in exchange receive the Japanese yen interest rate every month for the next year, for example.
- Stock Market Crash image by Paul Heasman from Fotolia.com