Risks to Hedging and Hedging

Risks to Hedging and Hedging Effectiveness

Over the last several years hedging has been used a strategy to reduce risk, in an era when market volatility can have severe effects on changing asset prices. Simply put, a hedge is when you are seeking to reduce the amounts of volatility by taking the opposite side of a trade. For example, if someone believes that Microsoft is going to face a sharp decline and a shareholder wants to protection against such situations; this would require the purchase of a put (the right to short a stock at a particular price). If the price of the stock declines, then the shareholder in Microsoft has protected themselves against the possible volatility. However, hedging is full of unique risks, that all traders and investors must be aware of. To determine the overall effectiveness of this strategy; requires that you consider the advantages that they have to offer and the risks that they present. This will tell any investor or trader if hedging is the most appropriate strategy they should be using with their portfolio.

Risks of Hedging

There are many different financial instruments that are used as part of any hedging strategy to include: forward contracts, options, insurance policies, futures contracts, stocks and swaps. The overall objective of any hedging strategy is to reduce the amounts of risk as much as possible. However, like all tools in investing hedging involves a balancing act between maintaining limiting risk, while ensuring that you are not experiencing opportunity cost. Together, these two elements will affect how and when a hedging strategy is implemented. This is significant; because when the hedge is implemented, it will determine how big of a profit or loss will be experienced by the organization / individual using this strategy. For example, if an airline decides to hedge against the volatility in fuel prices. The pricing and timing of the hedge will be most important, where if there is a delay in executing the strategy, the airline could pay more for downside risk protection. Then, if there is a reversal in the price of fuel, this could mean that the hedging strategy could produce a loss (instead of reducing the overall amounts of risk as much as possible). (Sooron, 2009) an example of this, occurred to Southwest Airlines, as they used hedging to provide earnings stability. However, when the price of fuel imploded in the fall of 2008, the hedging strategy backfired, with the company posting its first loss in 17 years. (Maynard, 2008) What this shows, is the overall risks of pricing and timing are important when using any kind of hedging strategy.

The Effectiveness of Hedging

While hedging has its fair share of risks, it has been shown to be an effective way of reducing the risk, without increasing the amounts of balancing required. This is because the markets are so volatile, that many traders and investors will often do periodic rebalancing. This could occur anywhere from every few days to at least once a year, depending upon the overall investment strategy that is being used. When you have to do consistent rebalancing, this means that the risk of the portfolio will increase, due fact that transactions costs increase. Then, the more rebalancing that takes place; the greater the possibility that you could be subject to the constant forces of fear and greed. This can cloud your judgment, which as a trader or investor it is imperative to think with a clear head. When you are placing the hedge, it is set at a logical point that is determined without emotions. This increases the chances that you have reduced your risks by eliminating the emotionalism that accompanies the markets. (Carr, 2002)

Another reason why hedging is effective, is it allows you to protect your downside using as little working capital as possible. Because hedging involves using options, means that the overall amounts of upfront costs are low. This means, that going into the hedge you know what your maximum down side will be (the premium). You can also reduce the amounts of risk by purchasing the options with expirations that are coming up, within the next 30 to 60 days. This is important, because the closer the option moves to the expiration date, the less it becomes. When you are hedging, you can purchase some of these cheaper options, protecting your downside as much as possible. While reducing, the amount of working capital you are investing in the hedging strategy. (Carr, 2002)