The general meaning of the word hedging is to protect oneself from losing or failing by a counterbalancing action. The specific meaning in finance is risk reduction with offsetting transactions that usually involve derivative securities. Hedge funds got their name because they originally hedged themselves against the downside risk of a bear market. Today, many hedge funds use strategies that are much riskier than the overall market, the exact opposite of hedging. We have already met hedging when we analysed the hedging portfolio in the binomial option-pricing model. In this chapter we take a more detailed look at some of the contracts involved in hedging and the way they are priced.
The basics of hedging
Hedging with futures and forwards has a long tradition, particularly in markets for agricultural commodities. This section elaborates a classic example from such markets. It also sketches some other ways to hedge risks, and the principles and motives behind the hedging decision.
The simplest way of hedging a risk is buying insurance against it. That is what most people and businesses do for rare and potentially catastrophic events such as fires and natural disasters. Other risks can be insured on the capital market. For example, investors can protect themselves against a price fall of certain securities by buying put options written on them, the ‘protective put’ we saw in Chapter 7. Conversely, investors can provide insurance to others, e.g. by buying catastrophe bonds that give reduced repayments if a specific catastrophe occurs.