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Hedging Explained

The Merriam-Webster dictionary defines hedging[1] as follows:

  1. To enclose or protect with, or as if with, a dense row of shrubs or low trees.
  2. To confine so as to prevent freedom of movement or action
  3. To protect oneself from losing or failing by a counterbalancing action.

i.e. “to hedge one’s strategy”

It’s the latter of the three definitions that we’re interested in from an investing point of view.Wikipedia goes a step further by defining a hedge as:

“An investment position intended to offset potential losses or gains that may be incurred by a companion investment.  In simple language, a hedge is a risk management technique used to reduce any substantial losses or gains suffered by an individual or an organization.”[2]

In the world of finance, hedges come in all shapes and sizes.  Unfortunately, they can be complicated to explain and understand, and they are often created using a product or contract called a “derivative”, a word that conjures up negative images of the 2008 credit crisis.  We’ll discuss derivatives in more detail in a future article; however, today let’s simply start by looking at an example of a hedge in action.

Imagine that you’re a farmer.  You’ve decided that the prospects for wheat look good this year so you’ll plant this crop.Of course once the seeds are in the ground you’re committed for the season.  If the price of wheat goes up between now and harvest time, you win.If the price goes down, you could lose a lot of money.  How do you protect yourself from that?

There are a couple of ways:

  1. You can enter into a contract with another individual or organization to deliver a certain amount of wheat at a particular date, for a price that gets specified in the contract.  This is called a “forward contract” and it allows you to guarantee a price that you will receive for your wheat regardless of the price of wheat at harvest time.While this contract or “hedge” will mean that you will lose the advantage of rising wheat prices at harvest time; it provides insurance that if the price of wheat falls, you have locked in a fair and profitable price for yourself.   Unfortunately, these forward contracts come with some risk.If for example, it’s a poor harvest, and you come up short on delivery, you’ll have to go out into the market and buy up the difference so you can make good on your contract. 
  2. Another alternative for you is to instead sell something called a “Futures Contract”.   These are standardized contracts that trade on exchanges.Unlike a forward contract, they are liquid, which means they can be bought and sold easily.  To protect yourself from a declining price in wheat, you would sell futures contracts for the amount that you expect to harvest.  Of note, no delivery of wheat is ever expected with a contract of this nature.  You will simply close it out at some point prior to the maturity date on the contract.  The result:You will either make money on the contract (because wheat prices declined) or lose money (because wheat prices rose).  If that seems a little backwards, remember, that if you make money on the futures contract, then the price of wheat has dropped and you’re going to be losing on the sale of your wheat at harvest time.  Similarly, if you lose money on the futures contract, then you’re going to be making money due to the price gain between the spring planting and harvest.  It is a counterbalancing action or hedge that you purposefully entered to protect yourself from a steep decline in wheat prices.

Now, as you can see from this example, hedging can have some real benefits when protecting a farmer from loss, although not without cost.  The same can be applied to investing.  There are many different hedging strategies available to investors.  In our next article, we’ll talk to you about one of the most common ones, which is to hedge against changes between the $US dollar and the $CDN dollar in US equity mutual funds.

In the meantime, if you’d like learn whether hedging may be appropriate for your own portfolio, we would urge you to give us a call at LGK Wealth Management.  We can be reached at (780) 426-2400 or send us an e-mail at LGKWealth@manulifesecurities.ca.

[1] https://www.merriam-webster.com/dictionary/hedge

[2] https://en.wikipedia.org/wiki/Hedge_(finance)

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