Hedging is the process of using derivative financial instruments to reduce the price risks that either arise in the course of normal business operations or are associated with investments. Hedging is one of the most important functions of financial markets. Traders performing hedging transactions are hedgers. Hedgers are often investors, producers, or major users of a given commodity who have preexisting risks associated with the price fluctuation of the specific investment or commodity.
There are many ways that hedging can be carried out through derivative instruments—that is, financial instruments that derive their values from the underlying assets, such as futures contracts, forward contracts, options, and swap agreements. For example, a futures contract allows the holder to carry out a transaction in the future at a price determined in the present. The value of the contract therefore depends upon the asset or commodity underlying the transaction. Hedging with futures contracts is fairly straightforward. Hedgers can hedge by either buying or selling futures contracts as a temporary substitute for a transaction to be made in the spot market. As long as spot and futures prices move together, any loss realized on one market (whether spot or futures) will be offset by a profit on the other market. Using options for hedging purposes is more complicated as it requires an analytical determination of the appropriate number of options contracts to buy or sell.
As an example of hedging with futures contracts, consider a corn farmer who anticipates selling certain bushels of corn three months from now and is concerned that the price of corn might fall in the next three months. The farmer may sell corn futures contracts for hedging. If corn prices in both spot and futures markets fall, the loss on the spot market will be offset by the profit on the futures market. Another example is related to a food-processing company that plans to purchase corn and is concerned that the price of corn might rise. The company can buy corn futures contracts for hedging. If the corn price rises, a loss on the spot market is met with a profit on the futures market, resulting in a reduced price risk.
A hedge is perfect if the gain (or loss) on the futures market matches perfectly with the loss (or gain) on the spot market. In practice, hedging may not be perfect because the difference between the spot price and the futures price (that is, the basis) may not converge to zero at the time the futures position is closed. Hedging effectiveness measures the extent to which the price risk is reduced through hedging. A hedge ratio is the number of derivative contracts transacted to reduce the price risk of a given position in the underlying asset. Hedging strategies are formed to choose the suitable derivative contracts and the amount of such contracts to be used. Traditional views hold that the optimal hedging strategy is one that maximizes the expected utility or minimizes the variance of the value of the hedged portfolio. Recent developments explore alternative approaches. For example, it is argued that a one-sided measure for hedging, such as the downside risk, is more accurate.
With the internationalization of financial markets, currency derivative instruments have increasingly been used to hedge currency risks in an international portfolio, which usually contains multiple risks. Optimal coordinated hedging strategies, which consider the effects of correlation among multiple risk factors in a portfolio, can be applied to hedge multiple risks and to achieve optimal hedging effectiveness.
The recognition of hedging as a purpose of derivatives transactions is important. Accounting rules treat the changes in the fair value of derivatives differently depending on the purpose for which the derivatives positions are entered. New derivatives that have been developed recently are intended to reduce quantity or revenue risks, which may complicate the appropriate accounting treatment.
SEE ALSO Discounted Present Value; Financial Markets; Forward and Futures Markets; Stock Options
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Financial Accounting Standards Board of the Financial Accounting Foundation. 1998. Accounting for Derivative Instruments and Hedging Activities. Stamford, CT: FASB.
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hedge / hej/ • n. a fence or boundary formed by closely growing bushes or shrubs: she was standing barefoot in a corner of the lawn, trimming the hedge. ∎ a contract entered into or asset held as a protection against possible financial loss: inflation hedges such as real estate and gold. ∎ a word or phrase used to allow for additional possibilities or to avoid overprecise commitment, for example, etc., often, usually, or sometimes. • v. [tr.] 1. (often be hedged) surround or bound with a hedge: a garden hedged with yews. ∎ (hedge something in) enclose. 2. limit or qualify (something) by conditions or exceptions: experts usually hedge their predictions, just in case. ∎ [intr.] avoid making a definite decision, statement, or commitment: she hedged around the one question she wanted to ask. 3. protect (one's investment or an investor) against loss by making balancing or compensating contracts or transactions: the company hedged its investment position on the futures market. PHRASES: hedge one's bets avoid committing oneself when faced with a difficult choice.DERIVATIVES: hedg·er n.