Hedging
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In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities.
Thus the hedger doesn't care whether the market as a whole goes up or down in value, only whether the under-priced security appreciates relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the security's theoretical value and its actual value (or between spot and futures prices in Working's time).
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging.
Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract.
Example of Hedging
A stock trader believes that the stock price of XYZ will rise over the next month, based on his information about the fundamentals of XYZ corporation. He wants to buy XYZ shares to profit from their expected price increase. But XYZ is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the XYZ shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (of shares x price) of the shares of XYZ's direct competitor, ABC corporation. If the trader were able to short sell an asset whose price had a mathematically defined relation with XYZ's stock price (for example a call option on XYZ shares) the trade might be essentially riskless and be called an arbitrage, which is the practice of taking advantage of a state of imbalance between two or more markets. But since some risk remains in the trade, it is said to be "hedged."
Ricky Schmidt
October 7, 2006
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