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Hedging in Investing
Hedging in Investing
Understand how investors use hedging to manage market risk.
Investing involves uncertainty. Prices can move because of economic conditions, interest rates, geopolitical events, currencies, commodities and changing investor sentiment.
Hedging is a risk-management technique designed to reduce the potential impact of adverse market movements on an existing investment or exposure.
Hedging is about managing risk — not eliminating it.
A hedge generally involves taking an offsetting position or using a financial instrument that may respond differently to the underlying investment.
If the original investment moves adversely, the hedge may generate a gain that offsets some of the resulting loss. If the original investment performs positively, however, the hedge can also reduce some of the potential upside.
The objective is therefore not necessarily to maximise returns. It is to manage the level and type of risk an investor is willing to accept.
Why would an investor hedge?
Investors may hedge when they want to remain exposed to an underlying asset while reducing the effect of a particular risk.
For example, an investor holding an international portfolio may be comfortable with the underlying investments but less comfortable with the effect of exchange-rate movements on the portfolio's value in their home currency.
Why investors consider hedging strategies.
Hedging can be particularly relevant when an investor has a concentrated position, international exposure or a defined period during which protecting capital matters.
Manage Downside Risk
An appropriate hedge may reduce the impact of adverse movements in the underlying investment.
Protect Existing Gains
Investors may use hedges when they want to protect some of an investment's accumulated gains without immediately selling the underlying position.
Manage Currency Exposure
International investments can create currency exposure in addition to the performance of the underlying asset.
Reduce Volatility
A hedge can potentially smooth the impact of certain market movements on an overall portfolio.
Maintain Investment Exposure
Hedging can allow an investor to retain an underlying position while separately addressing a specific risk.
Improve Risk Discipline
A defined hedging framework can help investors establish clearer parameters around acceptable exposure.
Before hedging, identify exactly what risk you are trying to manage.
Effective risk management starts with understanding the underlying exposure. An investor may be exposed to more than just the price of the asset itself.
Hedging, diversification and speculation are not the same thing.
Hedging
Hedging involves taking an offsetting position or using a financial instrument with the objective of reducing the impact of a specific risk.
Diversification
Diversification spreads exposure across different assets, sectors, regions or strategies in an effort to reduce concentration risk.
Speculation
Speculation generally involves taking market exposure with the expectation of profiting from a future price movement rather than primarily reducing an existing risk.
Hedging can be financial, operational or natural.
The right approach depends on the exposure, investment objective, timeframe and risk tolerance.
Using Financial Instruments
Financial hedging uses instruments such as forwards, futures, options and swaps to offset specific financial exposures.
Managing Exposure Through the Business
Natural hedging can involve matching revenues and costs in the same currency or structuring business operations to reduce exposure naturally.
Reducing Operational Exposure
Businesses may diversify suppliers, production locations or sourcing arrangements to reduce dependence on a particular market or region.
Managing Exposure With a Related Market
Cross hedging can be considered when a directly matching hedging instrument is unavailable, using a related asset with a meaningful relationship to the underlying exposure.
International investing creates another layer of risk.
When an investment is denominated in a foreign currency, the investor can be exposed to both the performance of the underlying asset and movements in the exchange rate.
Currency hedging can be used to address some or all of that FX exposure, depending on the investor's objectives.
Foreign Equities
Share-price performance and currency movements can both affect the value of an overseas investment.
Foreign Bonds
Investors can face both interest-rate and currency exposure when holding international fixed-income assets.
International Funds
Portfolio currency exposure can materially affect returns when assets are held in another currency.
Cross-Border Investments
Investors moving capital internationally may need to consider the timing and cost of currency conversion.
Financial instruments can provide different forms of protection.
Each instrument has different characteristics, costs, settlement requirements and risks.
Forward Contracts
A forward can allow an exchange rate to be agreed today for a transaction taking place at a future date.
Futures
Standardised exchange-traded contracts can be used to offset exposure to a range of financial assets.
Options
Options can provide a right, but not necessarily an obligation, to transact at a predetermined level.
Swaps
Swaps can be used by sophisticated market participants to exchange one stream of cash flows for another.
A hedge should support the investment strategy — not replace it.
Hedging should be considered in the context of the underlying investment and the risk being managed. The objective is to establish an appropriate balance between protection, cost, flexibility and retained market participation.
Four steps to thinking about investment hedging.
Identify
Identify the investment, currency or market exposure that creates the risk.
Measure
Consider the size, timeframe and potential impact of the exposure.
Hedge
Consider whether an appropriate hedging instrument or natural hedge can address the identified risk.
Monitor
Review the hedge as the underlying investment and market conditions change.
Understand your currency exposure before the market moves.
If your investment, business or international transaction creates currency exposure, Currency Hedger can help you understand the available FX risk-management solutions.
TALK TO AN FX SPECIALISTThe information on this page is provided for general educational and informational purposes only and does not constitute investment, financial, legal, accounting or tax advice, or a recommendation to buy or sell any financial instrument. Hedging involves costs and risks and may reduce potential gains as well as potential losses. The suitability of any hedging strategy depends on the individual circumstances, objectives and risk tolerance of the investor or business. Professional advice should be obtained where appropriate.