Hedging arrangement refers to an investment whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. Hedging provides a sort of insurance cover to protect against losses from an investment. It typically consists of shielding a portfolio by using one financial instrument investment to offset the risk of another investment.
What a Successful Hedging Arrangement Entails
Even though hedging does not eliminate risks completely, it can successfully mitigate losses. If the hedge works effectively, the investor’s profits will be protected or losses reduced, at least in part.
Derivatives Hedging Arrangement
Portfolio managers and other investors sometimes opt to use financial instruments known as derivatives to hedge other assets. The instruments may be either contingent claims or forward claims. Contingent claims include option contracts and futures contracts.
Options give investors the right to buy (with call options) or sell (with put options) securities at a specified price known as the strike price. Options contracts include put options where a buyer speculates a drop in prices while the option seller speculates a rise in prices. With call options, a buyer speculates prices will rise while a seller speculates prices will decline.
A futures contract is an arrangement between a buyer and a seller to buy and sell a given asset at a future date on a predetermined price. Both producers (such as farmers) and buyers in the cash market may hedge against possible price fluctuations by buying or selling futures contracts. Changes in the cash market price should, hopefully, be offset by corresponding changes in the futures price.
Overview of Forward Claims
Forward claims include swaps and forward contracts.
Swaps are derivatives contracts between two parties to exchange sets of cash flows determined by uncertain variables such as interest rates or commodity prices over a given pre-determined time frame. Common types of swaps include interest rate swaps, currency swaps, commodity swaps, and credit defaults swaps (CDS).
A forward contract is a customizable agreement to accommodate the parties involved in the buying and selling of a given asset. It’s usually based on a future date and price. Because it’s a non-standardized contract, it may be preferred over regular futures contracts. The main benefit of a forward contract lies in the ability to customize it to accommodate different commodities, delivery dates, and quantities.
Example of a Hedging Arrangement
Let’s assume Joe owns some shares in Oil Exploration Corporation (OEC). Lately, the company has been experiencing constant growth and market stability. Management believes the price of oil will remain on an upward trend, still increasing the value of the company’s stocks. However, Joe is a little bit skeptical. He thinks the price of oil will fall. Therefore, to hedge his investment in OEC stock, he sells short oil futures. Should oil prices decline, his futures investment will generate a profit that can offset possible losses from a decline in OEC’s stock price.
Diversification in Hedging Arrangements
When hedging, some investors sometimes just want to diversify their portfolios to reduce their overall risk exposure. General diversification contrasts with direct hedging in that it doesn’t usually consist of making specific investments to counterbalance other specific investments. Instead, it is just a matter of spreading investments across different market sectors or assets.
Thank you for reading CFI’s explanation of a hedging arrangement. CFI offers training and career advancement for finance professionals, including the Financial Modeling & Valuation Analyst (FMVA)™ certification program. To learn more and expand your career, explore the additional relevant resources below:
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