Calculating the presence of risks is but one part of investment strategy. Another important part is weighing the extent of those risks against the potential returns. For many market participants, such an analysis helps to gauge which investments are worth the risk and which ones should be avoided. For others, however, this calculation helps determine how much risk may be worth the potential returns, as well as what might be done to minimize the negative effects while experiencing a positive effect. At the core of this latter practice is the practice of financial hedging. As its name suggests, this term refers to placing investments within a framework that keeps losses to a minimum. This paper presents a careful analysis of the idea of financial hedging, how it is conducted and the positive and negative aspects to such a practice. The reader gleans a better understanding of how this concept is utilized to protect the interests of the investor.
Keywords: Derivatives; Futures; Hedge Fund; Option; Ponzi Scheme
Winston Churchill once commented on what he saw as the benefits to a life of uncertainties. "Without a measureless and perpetual uncertainty," he said, "the drama of human life would be destroyed" ("Winston Churchill quotes," 2006). In terms of investment practices, Churchill's statement certainly has validity. Indeed, much of market investment depends heavily on calculating risk and uncertainty in order to maximize returns and avoid loss.
Then again, calculating the presence of risks is but one part of investment strategy. Another important part is weighing the extent of those risks against the potential returns. For many market participants, such an analysis helps to gauge which investments are worth the risk and which ones should be avoided. For others, however, this calculation helps determine how much risk may be worth the potential returns, as well as what might be done to minimize the negative effects while experiencing a positive effect
At the core of this latter practice is the practice of financial hedging. As its name suggests, this term refers to placing investments within a framework that keeps losses to a minimum. This paper presents a careful analysis of the idea of financial hedging, how it is conducted and the positive and negative aspects to such a practice. The reader gleans a better understanding of how this concept is employed to protect the interests of the investor.
A Brief Overview of Hedging
There are countless factors within the vast series of networks which make up the capitalist market system that can impact, positively or negatively, a financial investment. For example, an American company that purchases a factory in China might see positive returns because of the strength of the US dollar against the Chinese yuan, but if that currency exchange rate falters, the return might be less than anticipated. Similarly, lending practices may be greatly enhanced by a federally-imposed reduction in interest rates, and conversely, leveled or increased interest rates may negatively impact the maturity of long-term investments.
Indeed, the financial world is affected by a myriad of influences, from inflation to war to weather. When a hurricane moves its way into the Gulf of Mexico, for example, its potential destructive force often causes oil companies to halt operations on off-shore oil drilling rigs. The lack of production in turn causes an increase in the average cost of fuel, which in turn impacts manufacturing facilities, transportation companies and the airline industry. Put simply, a storm located in one geographic region of the United States can send ripples across every sector of the American economy.
Because of these potential "flies in the ointment," investments always occur with risks. Of course, no investment can be perfectly sheltered from the elements. Still, some of the most critical but vulnerable corporate investments may be at least partially covered from such issues. In this regard, many investors, therefore, will seek to minimize these risks by entering into other investments or trade relationships that will properly frame the size of the return the investment will generate. In many cases, this is done by hedging the investment.
In 1949, Alfred Winslow Jones, who was a reporter for Fortune magazine, was researching an article about the latest in investment trends and market forecasting. During his study, he developed his own theories about how an investor might wisely direct his or her pursuits as well as how he or she might protect those investments from great risk. Jones raised $100,000, including $40,000 of his own money, to conduct a number of long-term market investments. However, this investment strategy included a set of short-term stock purchases and leveraged funds (borrowed money), which he added to his portfolio in order to offset risks to the long-term securities. Less than 20 years later, Jones's "hedge fund" was the top five-year mutual fund with an 85 percent return (Gabelli, 2000).
The practice of financial hedging varies in substance. In general, however, hedging in financial terms entails the use of derivatives that will offset the volatility of the investment. Derivatives are arrangements or contracts between two parties that are based on fluctuations and fluid conditions. The two most common types of derivatives are options and futures. An option is essentially a contract between an investment purchaser and seller whereby a security is bought based on the presumption that the value of the shares involved will either rise or fall compared to the agreed-upon price. The buyer will seek to purchase the share at a low point but believes that the shares will increase in value, while the seller will proceed from the idea that the stock price will fall compared to the agreed-upon price ("A beginner's guide to hedging," 2009). Under an option, the buyer is not under an obligation to buy or sell at a given price, but does reserve the right to do so.
The second type of derivative is a futures arrangement. Futures are contracts that arrange for the delivery of securities at a future date in exchange for a cash payment. Futures transactions occur within the framework of futures exchange markets, wherein the contracts are standardized (and not established by the parties themselves), performances are guaranteed by the market and gains and losses are carefully computed and managed by the exchange (Arditti, 1996). Because futures contracts create potential gains for the buyer but are carefully managed by a third party, they represent an effective tool by which financial hedging may occur.
Hedging may occur via hedge funds, which have since evolved from Alfred Jones's brainchild, or through other mechanisms. In many cases, an investor may imitate the classic hedge fund by investing 50 percent of his or her securities in a traditional long-term mutual fund (or more than one), and 50 percent in short-term mutual funds. Such 50-50 investment strategies have yielded an average return little more than 12 percent. Even during the bear market of 2002, an investment strategy along these lines might have included Prudent Bear, which saw a return rate of nearly 63 percent in 2000, and Meridean Growth Fund, which was experiencing the adverse impacts of a stagnant economy ("How to build your own hedge fund," 2005).
Financial hedging is an investment strategy designed to offset risks. While this financial pursuit would by its very definition suggest a positive return for the investor, there are positive and negative aspects to hedging. This paper will next turn to a study of the benefits and drawbacks of financial hedging.
The Benefits of Hedging
The list of financial hedging benefits begins with a point already discussed in this paper — the practice of hedging mitigates the risks of long-term investments. Hedge funds involve small investments that are...
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