Hedge (finance)
Encyclopedia
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.
A hedge can be constructed from many types of financial instruments, including stock
s, exchange-traded fund
s, insurance, forward contract
s, swaps
, options, many types of over-the-counter
and derivative
products, and futures contracts.
Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity
prices; they have since expanded to include futures contract
s for hedging the values of energy
, precious metal
s, foreign currency, and interest rate
fluctuations.
and other crops fluctuate constantly as supply and demand
for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that — forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.
If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat
at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.
believes that the stock
price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets
. He wants to buy Company A shares to profit
from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation
.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk
by short selling
an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B.
The first day the trader's portfolio
is:
(Notice that the trader has sold short the same value of shares)
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option
on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Value of short position (Company B):
Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
s use futures contract
s and derivatives
to hedge their exposure to the price of jet fuel
. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines
was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina
.
due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly.
This is a list of hedging strategies, grouped by category.
. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure.
Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.
One common means of hedging against risk is the purchase of insurance
to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.
One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures.
Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades).
Futures contract
s and forward contract
s are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.
Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.
pool. If the producer and the retailer agree to a strike price
of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer.
Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.
A hedge can be constructed from many types of financial instruments, including stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s, insurance, forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s, swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
, options, many types of over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
and derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
products, and futures contracts.
Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
prices; they have since expanded to include futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s for hedging the values of energy
Energy
In physics, energy is an indirectly observed quantity. It is often understood as the ability a physical system has to do work on other physical systems...
, precious metal
Precious metal
A precious metal is a rare, naturally occurring metallic chemical element of high economic value.Chemically, the precious metals are less reactive than most elements, have high lustre, are softer or more ductile, and have higher melting points than other metals...
s, foreign currency, and interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
fluctuations.
Etymology
Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s.Agricultural commodity price hedging
A typical hedger might be a commercial farmer. The market values of wheatWheat
Wheat is a cereal grain, originally from the Levant region of the Near East, but now cultivated worldwide. In 2007 world production of wheat was 607 million tons, making it the third most-produced cereal after maize and rice...
and other crops fluctuate constantly as supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that — forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.
If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat
Wheat
Wheat is a cereal grain, originally from the Levant region of the Near East, but now cultivated worldwide. In 2007 world production of wheat was 607 million tons, making it the third most-produced cereal after maize and rice...
at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.
Hedging a stock price
A stock traderStock trader
A stock trader or a stock investor is an individual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds as well...
believes that the stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets
Widget (economics)
The word widget is a placeholder name for an object or, more specifically, a mechanical or other manufactured device. It is an abstract unit of production. The Oxford English Dictionary defines it as "An indefinite name for a gadget or mechanical contrivance, esp. a small manufactured item" and...
. He wants to buy Company A shares to profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
by short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B.
The first day the trader's portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
is:
- LongLong (finance)In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
1,000 shares of Company A at $1 each - Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares)
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:
- Long 1,000 shares of Company A at $1.10 each: $100 gain
- Short 500 shares of Company B at $2.10 each: $50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
- Day 1: $1,000
- Day 2: $1,100
- Day 3: $550 => ($1,000 − $550) = $450 loss
Value of short position (Company B):
- Day 1: −$1,000
- Day 2: −$1,050
- Day 3: −$525 => ($1,000 − $525) = $475 profit
Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
Hedging Employee Stock Options
Employee Stock Options are securities issued by the company generally to executives and employees. These securities are more volatile than stock and should encourage the holders to manage those positions with a view to reducing that risk. There is only one efficient way to manage the risk of holding employee stock options and that is by use of sales of exchange traded calls and to a lesser degree by buying puts. Companies discourage hedging versus ESOs but have no prohibitions in their contracts.Hedging fuel consumption
AirlineAirline
An airline provides air transport services for traveling passengers and freight. Airlines lease or own their aircraft with which to supply these services and may form partnerships or alliances with other airlines for mutual benefit...
s use futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s and derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
to hedge their exposure to the price of jet fuel
Jet fuel
Jet fuel is a type of aviation fuel designed for use in aircraft powered by gas-turbine engines. It is clear to straw-colored in appearance. The most commonly used fuels for commercial aviation are Jet A and Jet A-1 which are produced to a standardized international specification...
. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines
Southwest Airlines
Southwest Airlines Co. is an American low-cost airline based in Dallas, Texas. Southwest is the largest airline in the United States, based upon domestic passengers carried,...
was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina
Hurricane Katrina
Hurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
.
Types of hedging
Hedging can be used in many different ways including foreign exchange trading. The stock example above is a "classic" sort of hedge, known in the industry as a pairs tradePairs trade
The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy...
due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly.
Hedging strategies
Examples of hedging include:- Forward exchange contract for currencies
- Currency future contracts
- Money Market Operations for currencies
- Forward Exchange Contract for interest
- Money Market Operations for interest
- Future contracts for interest
This is a list of hedging strategies, grouped by category.
Financial derivatives such as call and put options
- Risk reversalRisk reversal-Risk Reversal investment strategy:A risk-reversal consists of being long an out of the money call and being short an out of the money put, both with the same maturity....
: Simultaneously buying a call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
and selling a put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
. This has the effect of simulating being long on a stock or commodity position. - Delta neutralDelta neutralIn finance, delta neutral describes a portfolio of related financial securities, in which the portfolio value remains unchanged due to small changes in the value of the underlying security...
: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutralMarket neutralAn investment strategy or portfolio is considered market neutral if it seeks to entirely avoid some form of market risk, typically by hedging. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided...
strategy.
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such as the married putMarried put
A married put, or protective put, is a portfolio strategy where an investor buys shares of a stock and, at the same time, enough put options to cover those shares....
. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure.
Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.
One common means of hedging against risk is the purchase of insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.
Categories of hedgeable risk
There are varying types of risk that can be protected against with a hedge. Those types of risks include:- Commodity riskCommodity riskCommodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc...
: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products. - Credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discountedDiscounts and allowancesDiscounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...
rate. - Currency riskCurrency riskCurrency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another...
(also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure. - Interest rate riskInterest rate riskInterest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
: the risk that the relative value of an interest-bearing liability, such as a loan or a bondBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, will worsen due to an interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps. - Equity riskEquity riskEquity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods...
: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. - Volatility riskVolatility riskVolatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlyings is a major influencer of prices....
: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency. - Volumetric risk: the risk that a customer demands more or less of a product than expected.
Hedging equity and equity futures
Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased, or long futures when stock is shorted.One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures.
Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades).
Futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s and forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.
Futures hedging
Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa.Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.
Contract for difference
A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. Consider a deal between an electricity producer and an electricity retailer, both of whom trade through an electricity marketElectricity market
In economic terms, electricity is a commodity capable of being bought, sold and traded. An electricity market is a system for effecting purchases, through bids to buy; sales, through offers to sell; and short-term trades, generally in the form of financial or obligation swaps. Bids and offers use...
pool. If the producer and the retailer agree to a strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer.
Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.
Related concepts
- ForwardsForward contractIn finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
: A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract. - Forward Rate AgreementForward rate agreementIn finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
(FRA): A contract agreement specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract. - Currency option: A contract that gives the owner the right, but not the obligation, to take (call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
) or deliver (put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
) a specified amount of currency, at an exchange rate decided at the date of purchase. - Non-Deliverable Forwards (NDF): A strictly risk-transfer financial product similar to a Forward Rate AgreementForward rate agreementIn finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
, but used only where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. As the name suggests, NDFs are not delivered but settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currencyHard currencyHard currency , in economics, refers to a globally traded currency that is expected to serve as a reliable and stable store of value...
, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same; it's just that the supply of insured currency is restricted and controlled by government. See Capital ControlCapital controlCapital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account....
. - Interest rate parityInterest rate parityInterest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
and Covered interest arbitrageCovered interest arbitrageCovered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency...
: The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically provides the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if a person had invested in the same opportunity in the original currency. - Hedge fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
: A fund which may engage in hedged transactions or hedged investment strategies.
See also
- ArbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
- Asset-liability mismatch
- Diversification (finance)Diversification (finance)In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
- Fixed billFixed billFixed Bill refers to an energy pricing program in which a consumer pays a predetermined amount for their total energy consumption for a given period. The price is independent of the amount of energy the customer uses or the unit price of the energy...
- Foreign Exchange HedgeForeign exchange hedgeA foreign exchange hedge is a method used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies . This is done using either the cash flow or the fair value method...
- Fuel price risk managementFuel price risk managementA specialization of both financial risk management and oil price analysis – and similar to conventional risk management practice – fuel price risk management is a continual cyclic process that includes risk assessment, risk decision making, and the implementation of risk controls...
- Immunization (finance)Immunization (finance)In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
- List of finance topics
- Option (finance)Option (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
- SpreadSpreadSpread may refer to:*Statistical dispersion*Spread , an edible paste put on other foods*the score difference being wagered on in spread betting*the measure of line inclination in rational trigonometry...