Hedging

Hedging is an investment strategy designed to reduce the potential volatility in the value of a portfolio by reducing the risk of having losses embedded within that portfolio. A perfect hedge eliminates the possibility of future losses and thus preserves the initial value of the portfolio. It involves the simultaneous initiation of equal and opposite positions in the spot and futures markets. This offers investors certain knowledge of their future financial position but, because a perfect hedge also rules out any chance of making gains, it is an investment strategy only for the most risk-averse. Investors are more likely to opt for an imperfect hedge, whereby they attempt to insure themselves against only a proportion of potential losses. If, for instance, investors hold shares in a company whose price volatility historically has almost exactly matched that of the stock market index, they can offset the risk of a general market downturn by buying a derivative contract that will return a profit on that eventuality. This does not eliminate the risk of the individual share price falling for reasons that are unrelated to a general market downturn—hence, it is not a perfect hedge—but it does leave open the possibility that gains can be made if the individual share price performance proves to be strong.

Hedging is therefore a means of minimizing the speculative dimension of an investment portfolio. Arguably, the most basic assumption of investment finance is that risks and returns are directly proportional to one another: the higher the level of risk, the higher the likely return. To speculate is willingly to acquire additional forms of risk, in the hope that this will lead to enhanced future returns. To hedge, by contrast, is to seek protection from risks, albeit at the expense of enhanced future returns.

If this implies that hedging and speculating are entirely independent functions of investment activity, this might be somewhat misleading. All hedgers require speculators to construct the position that they intend to adopt as their hedge. Financial markets would lack the necessary counterparties that are fundamental to their existence if all investment strategies tended toward perfect hedging. Speculators accept the exposure to price moves that hedgers attempt to insure themselves against. In the absence of speculators, financial markets would cease to function in the way they do today because there would be no mechanism for transferring risk away from the risk-averse, and such transfers are the condition upon which modern financial systems are based. The task for public policymakers intent on preserving such systems, while rendering them stable, is far from straightforward. They must devise forms of market governance that offer sufficient incentives for speculators to act as counterparties for hedgers, while avoiding turning the whole of the financial system into an arena for pure speculation.