Hedge (Investment) – Definition

Cite this article as:"Hedge (Investment) – Definition," in The Business Professor, updated December 3, 2018, last accessed June 2, 2020, https://thebusinessprofessor.com/lesson/hedge-investment-defined/.

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Hedge (Investments) Definition

A hedge is a type of investment that involves an investor taking loss-limiting trading decisions to counter volatility in an asset’s value. A hedge is usually applied in a futures or options market and is intended to move in a direction opposite to that of the underling asset.

A Little More on What is Hedging One’s Investment Risk

Hedging is typically an anticipatory action that seeks to address the possible risks involved with making an investment decision. It is akin to an “insurance” that protects the investor from any eventual volatility of the asset. However, while it significantly reduces risks, hedging also potentially limits gains. In the non-event of a typical loss scenario, hedging might come across as an expensive or even unnecessary preventive action; however the same underlying philosophy is also applicable to insurance – better safe than sorry.

Experienced investors partake in hedges that promise comprehensive and faultless protection against volatility. However, even a hedge that seems perfect on paper might not always be capable of eliminating volatility in totality. Also, in sharp contrast to its intended purpose, a hedge may sometimes move in the same direction as the asset, thereby increasing “basis risk”. Moreover, let us face it – hedges are expensive.

Hedging By Way of Derivatives

Derivatives are an effective means of hedging. This type of securities not only has a market movement synchronous with that of the underlying assets but also has a well-defined relationship with them. Derivatives come in the form of futures, options, insurance, swaps and exchange traded funds and are used to effectively hedge not only stocks and bonds, but also commodities (such as precious metals), energy, currencies, and interest rates.

The “Hedge Ratio”, designated by the unit Delta measures the efficiency of a derivative hedge. In the simplest terms, it takes into account how much the derivative moves in price for every dollar that the price of the underlying asset changes.

Hedging By Way of Diversification

Hedging through derivatives is not only an expensive and complicated process but its success also depends on how accurate the risk calculations are. Luckily, there exists a much simpler, (albeit primitive) and cost-effective method of hedging in the form of diversification of portfolios. To a shrewd investor, it is of utmost importance to maintain a diversified portfolio so that losses incurred in certain stocks or utilities can be offset by gains made in others.

Diversification is a well-rounded strategy, no doubt, but the market is still at the mercy of unforeseen and potentially catastrophic natural events such as floods and earthquakes or even “man-made” events such as employee strikes.

References for Hedging

Academic Research on Hedging

Empirical characteristics of dynamic trading strategies: The case of hedge funds, Fung, W., & Hsieh, D. A. (1997). The Review of Financial Studies10(2), 275-302. This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds which can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.

Risks and portfolio decisions involving hedge funds, Agarwal, V., & Naik, N. Y. (2004). The Review of Financial Studies17(1), 63-98 This article characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. It shows that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. The article further demonstrate the extent to which the mean-variance framework underestimates the tail risk.

The risk in hedge fund strategies: Theory and evidence from trend followers, Fung, W., & Hsieh, D. A. (2001). The Review of Financial Studies14(2), 313-341. This article shows how to model hedge fund returns by focusing on the popular “trend-following” strategy. The paper uses lookback straddles to model trend-following strategies, and show that they can explain trend-following funds’ returns better than standard asset indices.

The performance of hedge funds: Risk, return, and incentives, Ackermann, C., McEnally, R., & Ravenscraft, D. (1999). The journal of Finance54(3), 833-874. This paper explores the different characteristics of hedge funds. It uses a large sample of hedge fund data from 1988–1995 to show that hedge funds consistently outperform mutual funds, but not standard market indices. The paper also suggests that hedge funds are more volatile than both mutual funds and market indices.  It also examines the impact of six data‐conditioning biases.

Common stocks as a hedge against inflation, Bodie, Z. (1976). The journal of finance31(2), 459-470. In this study, the authors test whether U.K. common stocks hedge against inflation using a framework of the tax-augmented Fisher hypothesis. Aggregate and disaggregate data covering 48 years are used.

Offshore hedge funds: Survival and performance 1989-1995, Brown, S. J., Goetzmann, W. N., & Ibbotson, R. G. (1997).  National Bureau of Economic Research. This paper examines the performance of the offshore hedge fund industry over the period 1989 through 1995 using a database that includes defunct as well as currently operating funds. The paper develops endogenous style categories for relative fund performance measures and find that repeat-winner and repeat-loser patterns in the data are largely due to style effects in that data.

Bivariate GARCH estimation of the optimal commodity futures hedge, Baillie, R. T., & Myers, R. J. (1991). Journal of Applied Econometrics6(2), 109-124. In this paper, six different commodities are examined using daily data over two futures contract periods. Cash and futures prices for all six commodities are found to be well described as martingales with near‐integrated GARCH innovations. The paper aims to show that the standard assumption of a time‐invariant OHR is inappropriate. The paper shows that for each commodity the estimated OHR path appears non‐stationary, and this has important implications for hedging strategies.

Hedge fund benchmarks: A risk-based approach, Fung, W., & Hsieh, D. A. (2004). Financial Analysts Journal60(5), 65-80. Following a review of the data and methodological difficulties in applying conventional models used for traditional asset class indexes to hedge funds, this article argues against the conventional approach. Instead, in an extension of previous work on asset-based style (ABS) factors, the article proposes a model of hedge fund returns that is similar to models based on arbitrage pricing theory, with dynamic risk-factor coefficients.

Hedge funds and the technology bubble, K. BRUNNERMEIER, M. A. R. K. U. S., & Nagel, S. (2004). The Journal of Finance59(5), 2013-2040. This paper documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. Findings from the study question the efficient markets notion that rational speculators always stabilize prices. They are also consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.

Performance characteristics of hedge funds and commodity funds: Natural vs. spurious biases, Fung, W., & Hsieh, D. A. (2000). Journal of Financial and Quantitative analysis35(3), 291-307. This paper advances the notion that the pro forma performance of a sample of investment funds contains biases. Emphasis is placed on performance measurement biases. This paper reviews the biases in hedge funds. It also propose using funds-of-hedge funds to measure aggregate hedge fund performance, based on the idea that the investment experience of hedge fund investors can be used to estimate the performance of hedge funds.

Do firms hedge in response to tax incentives?, Graham, J. R., & Rogers, D. A. (2002). The Journal of finance57(2), 815-839. This paper highlights the two incentives for corporations to hedge. The paper tests whether these incentives affect the extent of corporate hedging with derivatives.  Using an explicit measure of tax function convexity, the paper finds no evidence that firms hedge in response to tax convexity. Results from a study indicates that firms hedge because of expected financial distress costs and firm size.

Hedge fund activism, corporate governance, and firm performance, Brav, A., Jiang, W., Partnoy, F., & Thomas, R. (2008). The Journal of Finance63(4), 1729-1775. Using a large hand‐collected data set from 2001 to 2006, this paper finds that activist hedge funds in the United States propose strategic, operational, and financial remedies and attain success or partial success in two‐thirds of the cases. The paper provides important new evidence on the mechanisms and effects of informed shareholder monitoring with relations to fund hedging.

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