Hedging and How It Works With Examples
Protect yourself from financial crises
A hedge is an investment that protects your finances from a risky situation. Hedging is done to minimize or offset the chance that your assets will lose value. It also limits your loss to a known amount if the asset does lose value. It's similar to home insurance. You pay a fixed amount each month. If a fire wipes out all the value of your home, your loss is the only the known amount of the deductible.
Most investors who hedge use derivatives. These are financial contracts that derive their value from an underlying real asset, such as a stock. An option is the most commonly used derivative. It gives you the right to buy or sell a stock at a specified price within a window of time.
Here's how it works to protect you from risk. Let's say you bought stock. You thought the price would go up but wanted to protect against the loss if the price plummets. You'd hedge that risk with a put option. For a small fee, you'd buy the right to sell the stock at the same price. If it falls, you exercise your put and make back the money you just invested minus the fee.
Diversification is another hedging strategy. You own an assortment of assets that don't rise and fall together. If one asset collapses, you don't lose everything. For example, most people own bonds to offset the risk of stock ownership. When stock prices fall, bond values increase. That only applies to high-grade corporate bonds or U.S. Treasurys. The value of junk bonds falls when stock prices do because both are risky investments.
Hedges and Hedge Funds
Hedge funds use a lot of derivatives to hedge investments. These are usually privately-owned investment funds. The government doesn't regulate them as much as mutual funds whose owners are public corporations.
Hedge funds pay their managers a percent of the returns they earn. They receive nothing if their investments lose money. That attracts many investors who are frustrated by paying mutual fund fees regardless of its performance.
Thanks to this compensation structure, hedge fund managers are driven to achieve above market returns. Managers who make bad investments could lose their jobs. They keep the wages they've saved up during the good times. If they bet large, and correctly, they make tons of money. If they lose, they don't lose their personal money. That makes them very risk tolerant. It also makes the funds precarious for the investor, who can lose their entire life savings.
Hedge fund use of derivatives added risk to the global economy, setting the stage for the financial crisis of 2008. Fund managers bought credit default swaps to hedge potential losses from subprime mortgage-backed securities. Insurance companies like AIG promised to pay off if the subprime mortgages defaulted.
This insurance gave hedge funds a false sense of security. As a result, they bought more mortgage-backed securities than was prudent. They weren't protected from risk, though. The sheer number of defaults overwhelmed the insurance companies. That's why the federal government had to bail out the insurers, the banks, and the hedge funds.
The real hedge in the financial system was the U.S. government, backed by its ability to tax, incur debt and print more money. The risk has been lowered a bit, now that the Dodd-Frank Wall Street Reform Act regulates many hedge funds and their risky derivatives.
Gold is a hedge if you want to protect yourself from the effects of inflation. That's because gold keeps its value when the dollar falls. In other words, if the prices of most things you buy rises, then so will the price of gold.
Gold is attractive as a hedge against a dollar collapse. That's because the dollar is the world's global currency, and there's no other good alternative right now. If the dollar were to collapse, then gold might become the new unit of world money. That's unlikely because there is such a finite supply of gold. The dollar's value is primarily based on credit, not cash. But it wasn't too long ago that the world was on the gold standard. That means most major forms of currency were backed by their value in gold.
Gold's historical association as a form of money is the reason it's a good hedge against hyperinflation or a dollar collapse.
Gold can be bought as a direct investment if you think the price will go up, either because the demand will increase, or the supply will decline. That reason for purchasing gold is not a hedge.