How to Hedge an Investment

Matt Sauter

Uncertainty
The world we leave live in today is riddled with uncertainty and randomness. Throughout history, humans have attempted to understand this randomness and minimize uncertainty. Events that used to be attributed to gods and goddesses, such as weather and climate patterns, are now well researched and understood. The formerly mysterious and terrifying has now been turned into a science. Scientists and mathematicians have created complex models and principles which estimate weather patterns and stock prices, minimize variance, and ultimately produce reliable, robust prediction intervals for future events. As the science of estimating and controlling adverse events continues to advance, we also gain insight into how society controls exposure to risk. Utility theory, a theory that describes how humans act to maximize happiness, states that we are willing to suffer a small loss now, such as paying a small home insurance premium, to reduce or possibly eliminate the chance and severity of a random catastrophic loss. Home insurance acts as a hedge, or safeguard, against a very valuable asset a house.

Comment [SmF1]: Effective parenthetical definition here. Comment [SmF2]: While you do set up a context for understanding your argument, as is, if not for the title, it sounds as if the focus of the document will be utility theory since that is the only clearly defined term here. Maybe preview/refer to the next section? Comment [SmF3]: This is a nice and thorough explanation. But is hedging a process or a product? There needs to be a clear indication of this early in the documents. I neither case, it should be presented as such: For product descriptions, start with a sentence definition of the product and its various parts. This could become an extended definition if you think your audience needs more introductory information. Next, describe each part of the product in more detail, including its dimensions, materials, function, and relation to other parts. Conclude with a description of one complete operating cycle for the product. For process descriptions, start with a definition of the process and the different steps it involves. Again, this could become an extended definition if you think your audience needs more introductory information. Next, describe each step in more detail. Conclude with a summary of one complete cycle in the process. Formatted: Font: Bold Comment [SmF4]: OK here hedging is described as a process however, this information comes at the bottom of page 1 too late in the document. Formatted: Highlight Formatted: Highlight Formatted: Highlight Formatted: Highlight Comment [SmF5]: Nice, effective use of signal phrases/transitions through here. Helps guide the reader.

What is a Hedge?
Put simply, a hedge reduces losses if an adverse situation occurs. For example, taking out home owners insurance is a hedge on a house when a loss occurs, whether due to fire or another decrement, the insurance reduces the total losses incurred to the homeowner. The key point to understand is that hedging does not eliminate the chance of an unfavorable event from happening, but rather dampens the negative impact of such events if and when they occur. In other words, hedging reduces the severity, but not the frequency, of adverse events. The tradeoff of hedging is that through reducing downside risk, the potential gains are also reduced. This illustrates the classic risk-reward tradeoff that is commonplace in the world.

Terminology
As discussed above, home insurance acts as a hedge to reduce the loss severity given an event, such as fire, causes a loss. It is helpful to first understand some financial jargon before working through an example. In this scenario, the owner stands to profit if the value of the house increases, and will suffer if the value of the house increases. When this profit structure exists, it is called a long position. The insurance policy will cover a loss on the house and the premium paid will vary depending on the several variables such a total cost of the house. Insurance is defined in financial terms as a derivative it derives its value based on another asset. An insurance policy will pay out when a decrement causes a loss. A decrement can be loosely defined as an event that decreases the value of an asset, such as fire.

Generalization
In most cases hedging is more complex than home insurance. In todays financial environment there are many exotic assets that are exposed to more risks and uncertainty. A general process can be followed to hedge almost any asset. First, understanding what risks the asset are exposed to is very important. Next a risk-reward structure needs to be determined by the investor. Remember, reducing downside risk also reduces potential profits. Once a risk-reward structure is established, you select the correct financial instrument to perform the hedge. Finally, you calculate the final cost and implications of the hedge and ensure that the final outcome coincides with your goals and desires.

Asset Exposure
Different assets are exposed to different kinds of risks and uncertainty. An oil company is subject to regulation changes, labor costs, oil spills, etc. On the other hand, a large food production company is exposed to competitors taking market share, cost of transportation increasing (gasoline), and the weather affecting crop output which in turn increases their costs of input. It is the investors responsibility to understand these exposures, decide, which he should protect against, and ultimately determine a risk and reward structure that matches his desires.

Determine Risk-Reward Structure

To determine an appropriate risk and reward structure, the investor needs to determine the specific risk, and the amount of that risk to hedge. To illustrate this consider again a large food producer who is worried that gas prices will increase and shipping his food to stores will become too costly. The company therefore wishes to hedge gasoline prices. The next decision is to find the appropriate mixture of hedge costs and potential profits that meets the companys desires. One possible solution would be to lock in an affordable gasoline price by entering into a forward contract a contract to buy an asset at a specified price on a future date. Another option would be to buy shares in an oil company. If gasoline prices go up, the oil company will profit driving stock prices up and subsequently providing money, once the shares are sold, to the food company to help pay for increased cost of gasoline. The two preceding examples showcase two different hedging strategies with different costs and potential profit. When considering different risk-reward structures, a wise investor will look at the final implications of the different hedges.
Comment [SmF6]: Good to provide examples/extended definitions

Final Implications
Once several hedging options have been laid out, it is important to evaluate each position to see what risks are covered, how much of a loss will be covered if a loss occurs, and the net potential profit after considering the cost of the hedge. Lets take for example the simple case of being long Google stock. Figure A below shows your potential profit before a hedge. Assume that you want to eliminate any downside risk by buying a put option a derivative that much like home insurance will cover a loss if the asset, Google stock, decreases in value. Figure B shows the profit graph of the put option. The put option, however, was not free and has an associated cost that will slightly reduce potential profits. Figure C shows the final profit graph of the hedged position in Google stock. An analysis similar to the one illustrated above should be completed for each hedging strategy. Notice how the section of the graphs to the right of the purchase price, $, of Figure A and Figure B cancel out in Figure C. Furthermore, the resulting hedge still has profit potential if the price moves up from the original, also shown in Figure C. The selected strategy should have a potential profit graph that bests matches the desired risk and reward strategy desired.
Comment [SmF7]: ?

Comment [SmF8]: A bullet list might have worked well here.

Conclusion
From the regulated cars and highways we use in the morning, to the food we eat at lunch, we are constantly consuming the end products of risk controlled products to make our lives safer and to avoid catastrophic events. Although there are very specific and highly complicated hedging and risk controlling strategies out there, the general process remains the same. This general process of identifying the risks that we, our an asset, are exposed to, determining a risk and reward structure we are comfortable, and then hedging against those risks, can provide for a more stable, and comforting life in many respects. While the world is random and full of tragedies, the ability to make our futures more reliable with minimized chances of catastrophe, is a true human phenomenon that we all benefit from.

Comment [SmF9]: An interesting and slightly challenging topic. Overall, the explanation works the readers understanding of hedging is better at the end of the document than at the beginning. The set-up for the actual process definition, however, could have been a little more focused/reader friendly. All in all though, the document works. Grade = B+