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Hedge (finance)

What Does Hedge Mean?


Making an investment to reduce the risk of adverse price movements in an asset.
Normally, a hedge consists of taking an offsetting position in a related security, such as a
futures contract.

Hedging is the practice of taking a position in one market to offset and balance against
the risk adopted by assuming a position in a contrary or opposing market.The word hedge
is from Old English hecg, originally any fence, living or artificial. The use of the word as
a verb in the sense of "dodge, evade" is first recorded 1590s; that of insure oneself
against loss, as in a bet, is from 1670s. As a finance vehicle you divide your money as
with a fence, and bet some of it on opposite moves of the market so that if the undesirable
result occurs, then you minimize your loss. .

Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month,
due to the company's new and efficient method of producing widgets. He wants to buy
Company A shares to profit from their expected price increase. But Company A is part of
the highly volatile widget industry. If the trader simply bought the shares based on his
belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge
out the industry risk by short selling an equal value (number of shares × price) of the
shares of Company A's direct competitor, Company B.

The first day the trader's portfolio is:

• Long 1,000 shares of Company A at $1 each


• Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares)

If the trader was able to short sell an asset whose price had a mathematically defined
relation with Company A's stock price (for example a call option on Company A shares),
the trade might be essentially riskless. But in this case, the risk is lessened but not
removed.

On the second day, a favorable news story about the widgets industry is published and the
value of all widgets stock goes up. Company A, however, because it is a stronger
company, increases by 10%, while Company B increases by just 5%:

• Long 1,000 shares of Company A at $1.10 each: $100 gain


• Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the
Company A position. But on the third day, an unfavorable news story is published about
the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of
the widgets industry in the course of a few hours. Nevertheless, since Company A is the
better company, it suffers less than Company B:

Value of long position (Company A):

• Day 1: $1,000
• Day 2: $1,100
• Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):

• Day 1: −$1,000
• Day 2: −$1,050
• Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000
he has used in short selling Company B's shares to buy Company A's shares as well). But
the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25
during a dramatic market collapse.

What is the difference between hedging and speculation?

Hedging involves taking an offsetting position in a derivative in order to balance any


gains and losses to the underlying asset. Hedging attempts to eliminate the volatility
associated with the price of an asset by taking offsetting positions contrary to what the
investor currently has. The main purpose of speculation, on the other hand, is to
profit from betting on the direction in which an asset will be moving.

Hedgers reduce their risk by taking an opposite position in the market to what they are
trying to hedge. The ideal situation in hedging would be to cause one effect to cancel
out another. For example, assume that a company specializes in producing jewelry and it
has a major contract due in six months, for which gold is one of the company's main
inputs. The company is worried about the volatility of the gold market and believes that
gold prices may increase substantially in the near future. In order to protect itself from
this uncertainty, the company could buy a six-month futures contract in gold. This way, if
gold experiences a 10% price increase, the futures contract will lock in a price that will
offset this gain. As you can see, although hedgers are protected from any losses, they are
also restricted from any gains. Depending on a company's policies and the type of
business it runs, it may choose to hedge against certain business operations to reduce
fluctuations in its profit and protect itself from any downside risk.

Speculators make bets or guesses on where they believe the market is headed. For
example, if a speculator believes that a stock is overpriced, he or she may short sell the
stock and wait for the price of the stock to decline, at which point he or she will buy back
the stock and receive a profit. Speculators are vulnerable to both the downside and upside
of the market; therefore, speculation can be extremely risky. (To learn more, check out
the Short Selling tutorial.)

Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers.
Hedgers try to reduce the risks associated with uncertainty, while speculators bet against
the movements of the market to try to profit from fluctuations in the price of securities.

Arbitrage
In economics and finance, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking
advantage of a price difference between two or more markets: striking a combination of
matching deals that capitalize upon the imbalance, the profit being the difference between
the market prices. When used by academics, an arbitrage is a transaction that involves no
negative cash flow at any probabilistic or temporal state and a positive cash flow in at
least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical


arbitrage, it may refer to expected profit, though losses may occur, and in practice, there
are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit
margins), some major (such as devaluation of a currency or derivative). In academic use,
an arbitrage involves taking advantage of differences in price of a single asset or
identical cash-flows; in common use, it is also used to refer to differences between
similar assets (relative value or convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage
firm. The term is mainly applied to trading in financial instruments, such as bonds,
stocks, derivatives, commodities and currencies.

Examples
 Suppose that theexchange rates (after taking out the fees for making the exchange) in
London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6.
Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a
profit of ¥200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it
almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-
forward arbitrage (see interest rate parity) are much more common.
 One example of arbitrage involves the New York Stock Exchange and the Security
Futures Exchange OneChicago (OCX). When the price of a stock on the NYSE and its
corresponding futures contract on OCX are out of sync, one can buy the less expensive
one and sell it to the more expensive market. Because the differences between the prices
are likely to be small (and not to last very long), this can only be done profitably with
computers examining a large number of prices and automatically exercising a trade when
the prices are far enough out of balance. The activity of other arbitrageurs can make this
risky. Those with the fastest computers and the most expertise take advantage of series of
small differences that would not be profitable if taken individually.

Speculation
In finance, speculation is a financial action that does not promise safety of the initial
investment along with the return on the principal sum.[1] Speculation typically involves
the lending of money or the purchase of assets, equity or debt but in a manner that has not
been given thorough analysis or is deemed to have low margin of safety or a significant
risk of the loss of the principal investment. The term, "speculation," which is formally
defined as above in Graham and Dodd's 1934 text, Security Analysis, contrasts with the
term "investment," which is a financial operation that, upon thorough analysis, promises
safety of principal and a satisfactory return.[1]

In a financial context, the terms "speculation" and "investment" are actually quite
specific. For instance, although the word "investment" is typically used, in a general
sense, to mean any act of placing money in a financial vehicle with the intent of
producing returns over a period of time, most ventured money—including funds placed
in the world's stock markets—is actually not investment, but speculation.

Speculators may rely on an asset appreciating in price due to any of a number of factors
that cannot be well enough understood by the speculator to make an investment-quality
decision. Some such factors are shifting consumer tastes, fluctuating economic
conditions, buyers' changing perceptions of the worth of a stock security, economic
factors associated with market timing, the factors associated with solely chart-based
analysis, and the many influences over the short-term movement of securities.

There are also some financial vehicles that are, by definition, speculation. For instance,
trading commodity futures contracts, such as for oil and gold, is, by definition,
speculation. Short selling is also, by definition, speculative.

Financial speculation can involve the buying, holding, selling, and short-selling of stocks,
bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable
financial instrument to profit from fluctuations in its price, irrespective of its underlying
value.