A hedge is an investment product designed to offset the risk of adverse price movements in another asset. It usually means taking the opposite position to your main asset but in a related asset or security, often a derivative.
If you are speculating that the price of your core asset will rise – you are going long – you take a contrary position on your hedge to profit if the asset falls in price. If you are speculating that your core asset will fall – you are going short – you take a hedge positon that profits if it rises.
The hedge is designed to protect against market volatility.
But that oversimplifies it. There are lots of ways to hedge a risk and lots of risks you can hedge. And there are many types of hedges. But there are also many risks that you cannot hedge. In fact, the very word risk means different things to different people.
The primary definition of risk in the New Collins Concise Dictionary is, like the dictionary, concise. It is ‘the possibility of incurring misfortune or loss’. The dictionary then defines 'to take or run a risk' as being to proceed in action without regard to the possibility of danger involved.
The world of finance is awash with examples of risk. Our first task is to attempt to explain the broad concept of risk and the individual variations. The second is to suggest ways that risk exposure might be managed, mitigated or hedged.
Words of warning
It is probably appropriate to issue several words of warning. No single article, or even book, can possibly do the subject full justice. No matter how knowledgeable the writer and how comprehensive the writer's efforts, something will be missed, or simply prove impossible.
The diverse nature of market volatility means not every risk is manageable, mitigatable or hedgeable. In some cases the only option might be to decide not to pursue the intended course of action. The best advice might be to walk away from a proposed investment and not look back.
If you want or need a hedge and a hedge is not available, do not invest, cautions one long-term options trader. With some risks, the only way to hedge is not to buy.
The language of risk
Risk has a language all of its own. In his absorbing book, Financial Risk Management for Dummies, Aaron Brown, a risk manager at global investment firm AQR Capital Management at the time of writing the book, and a one-time professional poker player, sums it up neatly.
Although risk is one of the most important facts of life, language about it is extremely limited, he states. It's hard to discuss risk without expressing an opinion. People will say an investor was reckless, foolish or careless for taking a risk that turns out badly.
If things go well, that same person is judged as bold, innovative or a creative thinker. Even before you find out the result, if you like the risk you say the risk taker is shrewd, daring or taking a calculated risk. If you don't like a risk, the risk taker is rolling the dice or speculating.
No one said it was going to be easy
Managing risk, like managing any aspect of a business, is hard, writes Aaron Brown. But the task is made easier by having a well-planned strategy. A good risk management strategy is simple to state, if often difficult to carry out. It includes:
- Learning about the risks in general; learn about the business and the people
- Learning about specific exposures and risks; learn about the details of the portfolio
- Managing people, process, organisation; focus on group dynamics, the human factor
- Implementing damage control to minimise the impact when and if disaster strikes
In purely financial terms the word takes on a specialised meaning. Risk is the expected return above the “risk-free” rate. The risk-free rate is usually referenced to be the T-bill rate of US government securities – a return that is highly secure and typically the smallest available.
So, if an investor is researching an investment that offers a return of 5.5%, and the T-bill rate is 0.5%, the risk return is 5%.
The broadening of risk
General market risk has been broadened and enhanced by the actions of central bankers sponsoring quantitative easing, thereby removing fundamentals from valuations, says M Damian Billy, founder and CEO of Chicago-based private equity specialist Econophy Group.
He knows a thing or two about extreme risk, having served with the US Marines in Vietnam. Market risk has been magnified beyond historical parameters, he adds. He calculates that there is currently $63tr of global debt risk on the table.
“How much more exposure can be added before it is recognised as being fatal to all currencies and economies?” he asks, rhetorically.
M Damian Billy, courtesy of MDB
“At this time, the best hedge is keeping your powder dry if you long the market. At some point sanity will enter the environment and valuations will be adjusted accordingly, which is downward, across all asset classes. None is immune to manipulation or price distortion.”
The managing of risk
Managing risk is not minimising risk but rather managing the trade-off between risk and return, states Thomas S Coleman in his highly technical but very readable book A Practical Guide to Risk Management.
He says that good risk management allows the following possibilities:
- Same return with lower risk
- Higher return with the same risk
Generally the result will be a mix of higher return and lower risk.
Coleman adds that the ultimate goal of risk management is to build a robust yet flexible organisation and set of processes to respond to and withstand unanticipated events.
Thomas S Coleman, courtesy of Thomas S Coleman
Managing risk for crises, tail events or disasters requires the combining of all types of market risk, credit risk, operational risk, liquidity risks and others.
The causes of crises
Generally, Coleman notes, crises or disasters result from the confluence of multiple events and causes. He cites as examples the collapses of Barings, the bank, in 1890 and in 1995 and the Société Générale trading loss in January 2008. He might equally have pointed to The Royal Bank of Scotland and Lehman Brothers later in 2008.
In explaining what can be a tortuously complex subject, he compares the worlds of risk management in skiing (in particular avalanche risk) with financial risk management. This makes it much easier for the lay person to understand the concepts and practices involved in risk management.
A common problem for novice skiers, for example, is simply ignorance of the risks they are taking. There is a clear parallel with novice investors. Except for the asymmetry of payoffs. The penalty for a mistake in avalanche territory is injury, perhaps even death.
The penalty for a mistake in financial markets is losing one's money, or job. But the upside reward in financial markets can be high enough to create incentive problems and so pave the way for overleveraging, investing badly and crashing.
“Whatever the investment is, if there is a significant risk you can’t hedge maybe you should pass on the investment, or at least keep some cash in reserve; buy half or two-thirds instead of going all in,” advises Keith Ross, executive chairman of PDQ Enterprises, operator of a US equity trading platform.
Keith Ross, courtesy of pdq
“It is important to remember that the hedge will always have a cost and what many don’t realise is that when they hedge they are not eliminating risk (which most hedgers believe). They are just changing the nature or direction of the risk.”
This echoes a longstanding analogy in the market that links risk with fat. Risk, like fat, cannot be removed or eliminated, merely moved around the system. “You cannot protect yourself from risk,” says Martin Weale, a former member of the Bank of England Monetary Policy Committee.
The growth of leverage
One of the key ways in which risk has evolved over time revolves around leverage. New flavours and forms of risk are typically a variation on the leverage theme. Options give leverage to the call or put buyer and maybe some marginal return to the option writer, but the leveraged return to the option buyer is levered risk to the option seller.
Keith Ross argues that hedging a particular risk, be it interest rate, currency, or other, might not be as important as fully understanding the leverage in a portfolio.
He believes that all the major financial problems of recent decades - from the 1987 Crash, the Long-Term Capital meltdown (LTCM was bailed out in 1998 and dissolved in early 2008) and the sell-off in 2008-09 - were caused by the extent to which the big players were over-leveraged going into the crises.
They then exacerbated the crises with their need to reduce risk by selling on an industrial scale.
Too much leverage
One of the biggest risks is too much leverage, he says. This is not too hard to hedge, he advises. “Reduce the size of the position.”
Almost as a side note, he makes the point that all the financial products were centrally cleared by a third-party clearing facility.
Stocks are traded on exchanges and by broker-dealers who then settle and clear the trades through central clearing facilities such as the DTCC and NSCC (The Depository Trust & Clearing Corporation and the National Securities Clearing Corporation).
These clearing facilities act like a bank clearing cheques. They make sure that the accounts have sufficient funds and securities to meet their obligations. Futures are similar in that they are also centrally cleared.
The clearing facilities are responsible for maintaining margin levels that are sufficient for the volatility of the market.
All such contracts were paid for, settled and delivered during the crisis. The meltdown was in over-the-counter (OTC) contracts that were self-margined and in the end undercollateralised.
Specifics of risk
There are a number of specific risks that can identified. Many have a range of hedging strategies or techniques.
Thomas S Coleman divides liquidity risk into two sub-definitions: funding liquidity risk and asset liquidity risk. Funding liquidity refers to the ability to raise or retain the debt for financing leveraged positions. Asset liquidity refers to the ability to buy or sell in the necessary size at the prevailing market price in a timely fashion.
By Alex Gunningham from London, Perfidious Albion (UK plc) (Northern Rock Customers, Golders Green.) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons
For banks, liquidity risk means not having cash to hand to meet depositor demand for repayment (see Northern Rock and Lehman Brothers). For investors, it means not being able to sell an asset and turn it into cash.
This will usually, but not necessarily, be a long-term asset such as direct investment in property or an indirect investment via a property fund. Illiquidity can result in forced sales at significantly reduced prices, in turn creating buying opportunities for cash-rich vulture investors.
Private equity investors view this as a “liquidity premium” – the expected increase in return they require because their investment is by definition illiquid. If you own stock, and want a temporary market hedge you could go short the appropriate future or ETF but this then gives rise to tracking risk.
Risk cannot be eliminated, only moved around.
Interest rate risk
This is investor exposure to fluctuating interest rates. Property owners with experience of the mortgage market will have an instinctive understanding of the impact of movement in interest rates, especially if they are sizeable and rapid.
One of the simplest hedges for retail investors is to fix their mortgage rate for as long as practically possible. Fixed rate mortgages are readily available for a range of maturities, even up to 25 years.
Bank of England governor Mark Carney said at the press conference on 2 November 2017, explaining the Monetary Policy Committee’s (MPC's) decision to raise the key official rate from the first time since May 2007, to 0.5%: “Fully 60% of [UK] mortgages are at a fixed rate.”
A range of other interest rate solutions is available to the commercial client.
Governor Carney, image courtesy of the Governor and Company of the Bank of England
Interest rate swap
An interest rate swap is an agreement between a borrower and a bank to exchange interest payments on terms set out in the contract.
The borrower agrees to pay a pre-agreed fixed rate of interest. In return the borrower will receive from the bank a floating rate that matches the loan. In most cases, the bank will also be the lender.
The aim is to fix the cost of finance for a borrower who has floating rate borrowings. This protects the borrower from sharp increases in short-term interest rates.
Interest rate cap and floor
An interest rate cap is a contractual agreement between the borrower (the buyer) and the bank (the seller). The bank agrees to insure the borrower against a rise in the floating rate of interest above an agreed rate. In exchange, the borrower pays a cash premium to the bank, usually upfront.
The aim is to establish a maximum cost of finance for the floating rate borrower. This enables the borrower to enjoy the benefit of low short-term interest rates until they rise above the cap rate.
An interest rate floor guarantees the rate will not fall below a specified level.
Interest rate swap and floor
An interest rate swap and floor is a combination of an interest rate swap and an interest rate floor. The borrower agrees to pay a fixed rate of interest. In return the borrower receives a floating rate that matches the loan from the bank.
This gives the borrower the flexibility to benefit if the floating rate is below the floor strike rate. The premium for the floor is embedded in the swap rate; there is no upfront cash premium.
This product enables the borrower to benefit from a low interest rate environment. It also limits the potential penalty cost that could arise on early termination if interest rates are lower than at the beginning of the agreement.
A participating swap is an agreement between borrower and bank to exchange interest payments on agreed terms. It combines an interest rate swap with an interest rate cap. A pre-agreed portion of the notional amount is hedged with a swap; the remaining portion is hedged with a cap.
This gives the borrower protection against rising short-term interest rates, but the borrower retains the opportunity to benefit in a low short-term interest rate environment on the capped portion (this is referred to as the participation).
Interest rate swaption
An interest rate swaption is an option that gives a borrower the right - but not the obligation - to enter into an interest rate swap on an agreed date or dates in the future.
A swaption ensures a maximum fixed rate payable in the future. Furthermore, it gives flexibility if the fixed rate does not rise to the swaption strike rate at expiry; in this case, it will not be exercised and the borrower can take advantage of the lower market rates at that time.