¶ … Hedging and Its Importance to the Securities Markets
In simple terms, hedging is a form of insurance. It is a mechanism used to help shield investors and companies from the negative occurrences within the ordinary business environment. If properly hedged, when negative events do affect a business or individual, the damages incurred will be significantly less. A common example is that of insurance on an automobile or house. In the event of a catastrophic wreck or fire, and depending on the level of insurance purchased, an individual can recover the value of the lost car of home. In exchange for this reassurance, the individual would be required to pay monthly premiums whether or not the event actually occurred. In essence the individual is hedging him or herself against the likelihood of an event that would negatively impact the value placed on the particular car or home. Similarly, companies also hedge to reduce the impact of environmental factors on their business. For example, the airline industry is notorious for hedging against rising fuel and commodity prices. Hedging is so important within this industry that often, the company that can hedge more efficiently is frequently the most profitable company. Usually, when hedging, the instruments used have negative correlations. Correlation coefficients are used to determine the movements of two instruments when one instrument remains constant. The measurements are between negative one and positive one. A correlation coefficient of 1 means the instruments move in tandem with one another. A correlation coefficient of negative one means the instruments move in opposite directions, while a correlations coefficient near zero means there is no established relationship. Noting our previous example of the home and home insurance, the correlation between these two instruments would be near negative one. As the value of the house declines due to a catastrophic event such as a hurricane, the value of the insurance policy increases. Below is a simple chart depicting these movements.
Value of Home ($250,000)
Value of Insurance Policy ($0)
Value of home appreciates over the Value of policy remains constant
Holding Period
A negative event occurs such as a fire, hurricane, flood, or earthquake which destroys the home.
Value of Home ($0)
Value of Insurance Policy ($250,000)
Home is destroyed and has no value
Homeowner can now claim funds from policy
As can be seen from this example, hedging plays an important role of guarding against potential losses whether for an individual investor, corporation, or government.
Finally two commonly used hedging strategies used by companies are options and futures contracts. These instruments are used heavily be commodity intensive industries to keep the price of commodities fixed. For example, individual investor purchases shares of Unilever and wants to protect themself from the downside risk associated with the stock. The individual may enter into a put option which allows the individual to sell at a predetermined price. If the stock falls below this predetermined price, the investor in unaffected because of the prior price agreement. Similarly, Unilever may want to protect itself from the price volatility of tea used to produce its Lipton Ice tea product. In order to accomplish this, Unilever may decide to enter into a futures contract. This futures contact allows Unilever to purchase tea at a predetermined price in the future. This can be either a disadvantage or a superior competitive advantage for Unilever. If for example, the price of tea skyrockets, then the hedge would have been profitable. However, if the price of tea declines, Unilever is still obligated to pay the contracted price for the goods even if it's at a higher price. Over the course of this document, I will explain how Unilever uses hedging as a means to remain profitable in a global business environment.
Brief Company Overview: Unilever
Unilever is a home care, personal care, and food products supplier and distributor established in 1890. It has over 400 brands including Lipton and Slim Fast. These 400 products contribute to over $1 billion...
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