There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
Key Takeaways
- Market risk, or systematic risk, is the possibility that an investor will see huge losses as a result of factors that impact the overall financial markets, as opposed to just one specific security.
- Modern Portfolio Theory is one of the tools for reducing market risk, in that it allows investors to use diversification strategies to limit volatility.
- Another hedging strategy is the use of options, which allow investors to protect against the risk of big losses.
- Investors can also make trades based on market volatility by tracking the volatility index indicator, the VIX, often referred to as the "fear index," due to its tendency to spike during periods of greater volatility.
Modern Portfolio Theory
One of the main tools is themodern portfolio theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measures to determine an efficient frontier for an expected amount of return for a defined amount of risk. The theory examines the correlation between different assets, as well as the volatility of assets, to create an optimal portfolio.
Many financial institutions have used MPT in their risk management practices. The efficient frontier is a curved linear relationship between risk and return. Investors will have different risk tolerances, and MPT can assist in choosing a portfolio for that particular investor.
Options
Options are another powerful tool. Investors seeking to hedge an individual stock with reasonable liquidity can often buy put options to protect against the risk of a downside move. Puts gain value as the price of the underlying security goes down.
The main drawback of this approach is the premium amount to purchase the put options. Bought options are subject to time decayand lose value as they move toward expiration. Vertical put spreads can reduce the premium amounts spent, but they limit the amount of protection. This strategy only protects an individual stock, and investors with diversified holdings cannot afford to hedge each position.
Investors who want to hedge a larger, diversified portfolio of stocks can use index options. Index options track larger stock market indexes, such as the S&P 500 and Nasdaq. These broad-based indexes cover many sectors and are good measures of the overall economy.Stocks have a tendency to be correlated; they generally move in the same direction, especially during times of higher volatility.
Investors can hedge with put options on the indexes to minimize their risk. Bear put spreads are a possible strategy to minimize risk. Although this protection still costs the investor money, index put options protect a larger number of sectors and companies.
Volatility Index Indicator
Investors can also hedge using the volatility index (VIX) indicator. The VIX measures the implied volatility of at-the-money calls and puts on the S&P 500 index. It is often called the fear gauge, as the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 is very volatile. There are exchange-traded funds (ETFs) that track the VIX. Investors can use ETF shares or options to go long on the VIX as a volatility-specific hedge.
Of course, while these tools are certainly powerful, they cannot reduce all market risk.
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FAQs
Types of hedging strategies
What are the three common hedging strategies to reduce market risk? ›
At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate.
- Layering hedge to smooth rate impacts.
- Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.
What is the hedge that minimizes risk? ›
Delta hedging is commonly utilized in managing equity and options portfolios, ensuring risk is minimized. For instance, investment banks employ delta hedging to manage the risk associated with their options trading desks.
What is hedging for market risk? ›
Hedging against market risk
In summary, hedging is where you hold two or more simultaneous positions. The aim here is to offset losses in one area with gains in another. For example, in forex trading, you might have a long position on USD/GBP.
What is the most common hedge fund strategy? ›
The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued. Equities' correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds.
What are the 4 internal hedging techniques? ›
Internal FX Hedging Methods
- Invoicing in Domestic Currency. An obvious and simple way that exporters can hedge FX is by invoicing their customers in their own currency. ...
- Entering Into a Risk Sharing Agreement. ...
- Leading and Lagging. ...
- Price Variation. ...
- Matching. ...
- Doing Nothing. ...
- Forward Trades. ...
- Option Trades.
Some common hedging strategies are as follows:
- Long/Short Strategy: This strategy involves simultaneously holding long and short positions in correlated securities. ...
- Pair Trading: Pair trading involves identifying two correlated securities and taking opposite positions to profit from their relative price movements.
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.
How to hedge for a market decline? ›
11 Tips on How to Hedge Against Market Crash
- Invest in Collectibles Like Fine Wine. ...
- Invest in Hard Assets Like Real Estate. ...
- Invest in Gold. ...
- Invest in Fixed Income Products Like Treasury Bonds. ...
- Invest in Market-Hedged Products. ...
- Diversify Your Investment Portfolio. ...
- Time the Market. ...
- Buy VIX Call Options.
The main purpose of hedging in corporate finance is to minimise potential losses arising from uncertainties in the market, like fluctuations in interest rates, exchange rates, and commodity prices.
Can hedging eliminate all risk? ›
Ineffectual: Hedging may not always be successful. Unstructured hedges may not be useful to mitigate losses. Unforeseen Market Conditions: The market is unpredictable and can have a direct impact on investment. Hedging cannot remove the risk completely, hence may not always be useful to overcome risks.
Is hedging a good strategy? ›
Hedging strategies are used by investors to reduce their risk exposure in the event that an asset in their portfolio experiences a sudden price decline. Hedging strategies, when used correctly, reduce uncertainty and limit losses while not significantly reducing the potential rate of return.
What is an example of hedging options? ›
For example, if a farmer wanted to hedge against their crop of wheat losing its value, they could take out an option to sell their product at the current market price. This would ensure that regardless of market movements, they have the choice to sell it at the expiry date – but not the obligation.
How to do hedging in the stock market? ›
Investors can use futures contracts to hedge against future price changes in the underlying asset. For example, if an investor owns a stock and fears a drop in its value, they could sell a futures contract at the current price to lock in the current value and protect against a decline in the future.
How to hedge against inflation? ›
The most common asset classes for protection against inflation include gold, commodities, a balanced and diversified portfolio with a 60/40 split between stocks and fixed income, real estate investment trusts (REITs), rental income from real estate, the S&P 500, and TIPS.
What are the three types of hedge transactions? ›
Learn about hedging and explore the three main types of hedging transactions in foreign operations: Cash flow hedges, fair value hedges, and net investment hedges.
How many types of hedging strategies are there? ›
There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
What is the hedging strategy in the stock market? ›
A hedging strategy is a way of reducing the risk exposure to financial assets. The popular hedging method involves offsetting positions in derivative products corresponding to an existing position. Other means, such as diversification, can also be used to build additional hedges.
