Hedging

Hedging

Hedging through derivatives - Derivatives are securities that move in terms of one or more underlying assets; they include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.
1. Delta - The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the "hedge ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the price of the underlying asset.
  1. Delta-Gamma Hedging - In options, delta refers to a change in the price of an underlying asset, while gamma refers to the rate of change of delta.
Hedging through Diversification
1. Cross-hedging - A cross hedge is the act of hedging ones position by taking an offsetting position in another good with similar price movements. A cross hedge is performed when an investor who holds a long or short position in an asset takes an opposite (not necessarily equal) position in a separate security, in order to limit both up- and down-side exposure related to the initial holding.
Short Hedge - A short hedge is an investment strategy utilized to protect against the risk of a declining asset price at some time in the future. It is typically focused on mitigating the risk of a current asset held by a company. The strategy involves shorting an asset with a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.
Rolling Hedge - A rolling hedge is a strategy for reducing risk that involves obtaining new exchange-traded options and futures contracts to replace expired positions. In a rolling hedge an investor gets a new contract with a new maturity date and the same or similar terms.
Natural Hedge - A natural hedge is a method of reducing financial risk by investing in two different financial instruments whose performance tends to cancel each other out. A natural hedge is unlike other types of hedges in that it does not require the use of sophisticated financial products such as forwards or derivatives. However, most hedges (natural or otherwise) are imperfect, and do not eliminate risk completely.
Hedge Ratio - The hedge ratio compares the value of a position protected through the use of a hedge with the size of the entire position itself. A hedge ratio may also be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged. For example, imagine you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk. The hedge ratio is important for investors in futures contracts, as it identifies and minimizes basis risk.
1. Basis Risk - the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

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