Hedging in finance

Hedge in finance

A hedge fund refers to a lightly regulated private investment fund sometimes characterized by unconventional strategies. Primarily organized as limited partnerships, and previously were often simply called limited partnerships and were grouped with other partnerships such as those that invested in oil development.

Hedging involves eliminating certain aspects of risk from your position. These could include anything from sector risk, industry risk to market risk (also referred to as systematic risk), and much more. When hedging you usually offset long position with short positions and vice versa. . Hedging is a strategy to minimize exposure in unwanted business risk, while still allowing the business to profit from an investment activity. A hedger might invest in a security he believes is under priced relative to its "fair value" , and combine this with a short sale of a related security or securities. Thus the hedger doesn't care if the market goes up or down in value, only whether the under priced security appreciates relative to the market. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the security's theoretical value and its actual value.

Hedging: an example

In the simplest example of a currency hedge, a Briton planning to move to Canada in six months taking £100,000 with her might 'insure' against currency movements. With sterling high and the Canadian $r low, it could be wise for a traveller to take action now while the exchange rate is so favourable. She might buy Canadian dollars now instead of waiting six months. That is one form of hedging. But it is unlikely she could be in a position to put all her funds now into a Canadian currency. Instead she might buy options over £100,000 worth of Canadian dollars which will cost far less. The options bought would allow a traveller to buy a currency for a set price in six months. If the currency rises, or the pound falls she retains a right to buy at a more favourable rate by exercising options. If the opposite happens, she lets her options expire and loses what she paid for the option that's the insurance cost. In buying now, protection against a worsening in the exchange rate has been bought - her funds have now been 'hedged' against future possibilities.

A hedge fund has emerged as one of the UK's most generous philanthropists. In 2006 accounts just filed show the fund - The Children's Investment Fund (TCI) - gave £50.4m to its charitable arm in the year to 31 August, 2005. The charity connected to the fund, the Children's Investment Fund Foundation, works to alleviate child poverty in the developing world. The hedge fund hands over up to 1% of its assets to the charity. At present, the foundation is endowed with £63m, and TCI has put a further £33m into another charity registered in the USA.

Notable hdge fund inventors include Eric Mindich, Estlander & Rönnlund, and George Soros.

At the end of 2004, 55% of the number of hedge funds, managing nearly two-thirds of total hedge fund assets, were registered offshore. The most popular offshore location was the Cayman Islands followed by British Virgin Islands and Bermuda. The USA was the most popular onshore location accounting for 34% of the number of funds and 24% of assets. EU countries were the next most popular location with 9% of the number of funds and 11% of assets. Asia accounted for the majority of the remaining assets.

The USA Senate Judiciary began investigating into the propriety of Hedge Funds on June 28, 2006. The hearings have been recently reported on by CNBC, Boomberg, and Marketwatch after a New York Times article exposed an investigation by Gary Aguirre, an investigating attorney, who was recently fired by the SEC.

The bulk of hedge fund assets are invested in funds employing "long / short" equity strategies. Other hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. When strategies become complex they may acquire potential and unanticipated risk of catastrophic losses as in the case of Long Term Capital Management.

Some form of risk taking is inherent to any business activity. Some risks are considered natural to specific businesses, e.g. risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, takes care of the risk of competition, of poor or unpopular products, and so on, has natural risks. The risk of their inventory being destroyed by fire is unwanted, so can be hedged via a fire insurance contract.

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, types of hedges have increased greatly. In general, all hedge strategies look for a "spread" between market value and theoretical or "true" value, and attempt to extract profits when the values converge.

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. For instance, consider a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If a producer and retailer agree to a strike price of USA$50 per MWh, for 1 MWh in a trading period, and if the actual pool price is USA$70, then the producer gets USA$70 from the pool but has to rebate USA$20 (the "difference" between the strike price and the pool price) to the retailer.

Categories of hedgeable risk
For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.

Interest rate – the risk, for those who borrow, that interest rates will rise, (or for those who lend, that they fall)
Equity – the risk, for those whose assets are equity holdings, that the value of the equity falls
Futures contracts and forward contracts are a means of hedging against risk of adverse market movements. These originally developed from commodity markets in the 19th century, but over the last fifty years there developed a huge global market in products to hedge financial market risk.

Hedging credit risk
Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.
Hedging insurance risk
One of the oldest means of hedging against risk is the purchase of protection against accidental property damage or loss, personal injury, or loss of life.

More recent forms of hedging have become available in the credit derivatives market.
Hedging Currency Risk
Currency hedging is used by financial investors to parse out the risks they encounter when investing overseas, as well as by non financial actors in the global economy for whom multi-currency activities is a necessary evil rather than a desired state of exposure.

The term hedge fund dates to the first such fund founded by Alfred Winslow Jones in 1949. Jones' innovation was to sell short some stocks while buying others, thus some of the market risk was hedged. While today's hedge funds still trade stocks both long and short, many do not trade stocks at all. For example, cost of labour variables dictate that much of the simple commoditized manufacturing in the global economy today goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of never having done business in foreign countries, so many businesses are jumping into the fray and becoming part of the globalization trend of moving manufacturing operations overseas. The benefits of doing this, come with numerous risks never a problem when manufacturing was done at home.

Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

Two types of arbitrage are possible: In cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Before the acquisition is completed, the stock of the target trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock. In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur will then short sell the acquirer and buy the stock of the target. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into her short position to complete the arbitrage.

Some hedge fund strategies fail. LTCM suffered losses of around $4bn from bets on global bond markets that got hit during the Russian financial crisis in the late nineties. As investors moved their funds in a rush into more secure bonds, prices rose quickly and yields fell - a development largely unforeseen by LTCM and perhaps others. Its capital, nearly $5bn at the start of the year, stood at $600m before the bailout, sources said. Hedging investments are often made with a high degree of borrowed money, raising the risks of problems of things go wrong. LTCM borrowed heavily for its fund investments. Now its investors are paying the price. Hedge funds scored some spectacular successes in the 1990s, generating annual returns of 30% or more for investors. But the 1998 collapse of the US-based LTCM hedge fund, which had invested heavily in the crisis-hit Russian market, sent tremors through financial markets worldwide.

In 98 another speculative hedge fund has fell victim to chaos on the world's financial markets and acknowledged staggering losses. Everest Capital, a hedge fund based in Hamilton, Bermuda, wrote off $1.3bn of the $2.7bn it was managing at the start of the year. One of the funds, Everest Capital Frontier Fund, specialising in emerging markets like Russia and Latin America, lost more than half of its value during one month alone, and 68% in a year. Everest's other major fund lost 42% through August. This made the company one of the hedge funds hit hardest by the turmoil in the global markets.

In 2006 a hedge fund in the UK went to political controversy when interest grew in the investments of David Mills, husband of Culture Secretary Tessa Jowell, hedge funds were now firmly in the headlines. Their popularity among rich investors and institutions grew sharply in recently. But few outside investment communities know much about how they work, or what their benefits are. The kind of fund in which Mr Mills invested £400,000 use financial derivatives, often in leveraged bets. At a basic level, this could take the form of acquiring a stock that appears undervalued - either outright or by buying a call option that gives the fund the right to buy the stock at today's price even if the market price goes up. In the case of David Mills, an international lawyer, he and Ms Jowell say they took out £400,000 mortgaging on their house to buy in a Guernsey hedge fund. The loan was paid off only weeks later with money from another fund. But according to Neil McKinnon, hedge fund manager and chief economist of ECU Group, it was unusual for high net worth individuals to take out short term mortgages to invest in hedge funds. Italian prosecutors alleged there is a connection between a loan secured on the house which Mr Mills and Ms Jowell jointly own, and a £344,000 payment received by Mr Mills.

In 2002 The Financial Services Authority in the UK was debating whether to allow ordinary savers to put their money into high-risk 'hedge funds'.
Hedge funds, currently the preserve of the wealthy, aim to maximise returns through potentially lucrative but risky investment strategies. The City watchdog said its move came in response to rapid growth in the hedge fund industry, raising the possibility that ordinary investors might start taking an interest in their products and services.

In finance, short selling or "shorting" is a way to profit from a decline in price of a security, such as stock or bond. Most investors "go long" on an investment, hoping prices rise. To profit from a stock price going down, a short seller can borrow a security and sell it, hoping that it will decrease in value so that they can buy it back at a lower price and keep the difference. For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit. This practice has the potential for an unlimited loss, for example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500. Short selling has been a target of ire since at least the 17th century when England banned it outright. Short sellers are widely regarded with suspicion because, to many people, they are profiting from the misfortune of others. However, academic studies have generally lauded short-selling as an important contribution to stock market efficiency.

In the year 2000 hedging was blamed for contributing to downward pressure on the priceof Gold. which hit a 20-year low of almost $250 (£156) in 1999, because it contributed to flooding the market.

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