Hedging

A strategy employed in the futures, options and warrants markets to reduce risk by making a transaction in one market to protect against a loss in another. Traditionally a commodity producer (say, a cocoa grower) would agree to sell his goods at a stated price at a stated time in the future, and the user of the commodity (say, a chocolate manufacturer) would agree to buy them. By agreeing on a price, quantity and delivery date, they introduce certainty into their operations and reduce risk. For the producer, the risk would be that prices drop, and for the processor that they would rise. In the financial markets, options and warrants can be used to hedge a portfolio position. In the case where shares have been sold, for example, the purchase of equivalent call options (the option to buy shares) means that if the shares rise in price, a corresponding rise in the value of the option will offset the notional loss expected on the underlying shares.

A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. Hedging employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets). Hedging is used also in protecting one's capital against effects of inflation through investing in high-yield financial instruments (bonds, notes, shares), real estate, or precious metals. 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.

financial derivatives
These nancial instruments promise payoffs that are derived from the value of something else, which is called the underlying. The underlying is often a nancial asset or rate, but it does not have to be. For example, derivatives exist with payments linked to the S&P 500 stock index, the temperature at Kennedy Airport, and the number of bankruptcies among a group of selected companies. Some estimates of the size of the market for derivatives are in excess of $270 trillion more than 100 times larger than 30 years ago. When derivative contracts lead to large nancial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings Bank (the Queen of Englands primary bank) and Long-Term Capital Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that derivatives are nancial weapons of mass destruction, carrying dangers that, while michael Morgenstern now latent, are potentially lethal. But there are two sides to this coin. Although some serious dangers are associated with derivatives, handled with care they have proved to be immensely valuable to modern economies, and will surely remain so.

the nuts and bolts

Derivatives come in avors from plain vanilla to mint chocolate-chip. The plain vanilla include contracts to buy or sell something for future delivery (forward and futures contracts), contracts involving an option to buy or sell something at a xed price in the future (options) and contracts to exchange one cash ow for another (swaps), along with simple combinations of forward, futures and options contracts. (Futures contracts are similar to forward contracts, but they are standardized contracts that trade on exchanges.) At the mint chocolate-chip end of the spectrum, however, the sky is the limit.

Forward Contracts
A forward contract obligates one party to buy the underlying at a xed price at a certain future date (called the maturity) from a counterparty, who is obligated to sell the underlying at that xed price. Consider a U.S. exporter who expects to receive a 100 million payment for goods in six months. Suppose that the price of the euro is $1.20 today. If the euro were to fall by 10 percent over the next six months, the exporter would lose $12 million. But by selling euros forward, the exporter locks in the current forward exchange rate. If the forward rate is $1.18 (less than $1.20 because the market apparently expects the euro to depreciate a bit), the exporter is guaranteed to receive $118 million at maturity. Hedging consists of taking a nancial position to reduce exposure to a risk. In this example, the nancial position is a forward contract, the risk is depreciation of the euro, and the exposure is 100 million in six months, which is perfectly hedged with the forward contract. Since no money changes hands when the exporter buys euros forward, the market value of the contract must be zero when it is initiated, since otherwise the exporter would get something for nothing.

Options
Although options can be written on any underlying, lets use options on common stock as an example. A call option on a stock gives its holder the right to buy a xed number of shares at a given price by some future date, while a put option gives its holder the right to sell a xed number of shares on the same terms. The specied price is called the exercise price. When the holder of an option takes advantage of her right, she is said to exercise the option. The purchase price of an option the money that changes hands on day one is called the option premium. Options enable their holders to lever their resources, while at the same time limiting their risk. Suppose Smith believes that the current price of $50 for Upside Inc. stock is too low. Lets assume that the premium on acall option that confers the right to buy shares at $50 each for six months is $10 pe share. Smith can buy call options to purchase 100 shares for $1,000. She will gain from stock price increases as if she had invested in 100 shares, even though she invested an amount equal to the value of 20 shares. With only $1,000 to invest, Smith could have borrowed $4,000 to buy 100 shares. At maturity, she would then have to repay the loan. The gain made upon exercising the option is therefore similar to the gain from a levered position in the stock a position consisting of purchasing shares with ones own money plus money thats borrowed. However, if Smith borrowed $4,000, she could lose up to $5,000 plus interest if the stock price fell to zero. With the call option, the most she can lose is $1,000. But theres no free lunch here; shell lose the entire $1,000 if the stock price does not rise above $50.

Swaps
A swap is a contract to exchange cash ows over a speci c period. The principal used to compute the flows is the notional amount. Suppose you have an adjustable-rate mortgage with principal of $200,000 and current payments of $11,000 per year. If interest rates doubled, your payments would increase dramatically. You could eliminate this risk by re- nancing with a xed-rate mortgage, but the transaction could be expensive. A swap contract, by contrast, would not entail renegotiating the mortgage. You would agree to make payments to a counterparty say a bank equal to a xed interest rate applied to $200,000. In exchange, the bank would pay you a oating rate applied to $200,000. With this interest-rate swap, you would use the oating-rate payments received from the bank to make your mortgage payments. The only payments you would make out of your own pocket would be the xed interest payments to the bank, as if you had a xed-rate mortgage. Therefore, a doubling of interest rates would no longer affect your out-ofpocket costs. Nor, for that matter, would a halving of interest rates.

Definition of 'Currency Risk'

A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Investopedia explains 'Currency Risk'

For example, if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the U.S. dollar. So, if you realize a 15% return in your Canadian stocks but the Canadian dollar depreciates 15% against the U.S. dollar, this will amount to no gain at all. Academic studies of currency risk suggest - although without absolute certainty - that investors bearing currency risk are not compensated with higher potential returns, meaning it is essentially a needless risk to bear.

Risks of International Investments.

Several levels of investment risks are inherent in foreign investing: political risk, local tax implications and exchange rate risk. Exchange rate risk is especially important, because the returns associated with a particular foreign stock (or mutual fund with foreign stocks) must then be converted into U.S. dollars before an investor can spend the profits. Let's break each risk down.

Portfolio Risk The political climate of foreign countries creates portfolio risks because governments and political systems are constantly in flux. This typically has a very direct impact on economic and business sectors. Political risk is considered a type of unsystematic risk associated with specific countries, which can be diversified away by investing in a

broad range of countries, effectively accomplished with broad-based foreign mutual funds or exchange-traded funds (ETFs). Taxation Foreign taxation poses another complication. Just as foreign investors with U.S. securities are subject to U.S. government taxes, foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are typically withheld at the source country before an investor can realize any gains. Profits are then taxed again when the investor repatriates the funds. Currency Risk Finally, there's currency risk. Fluctuations in the value of currencies can directly impact foreign investments, and these fluctuations affect the risks of investing in non-U.S. assets. Sometimes these risks work in your favor, other times they do not. For example, let's say your foreign investment portfolio generated a 12% rate of return last year, but your home currency lost 10% of its value. In this case, your net return will be enhanced when you convert your profits to U.S. dollars, since a declining dollar makes international investments more attractive. But the reverse is also true; if a foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the returns of the foreign position.

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position. In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice, depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U.S. dollar