Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 7 Hedging

Traders can make trades that reduce the risk of other investments. This process is called hedging. Hedging locks in profits and losses in one investment by taking an offsetting position in a similar tradable investment. Hedging is commonly done to allow tradable instruments (like crude oil futures) to offset the price risk associated with operating a non-tradable asset (like an oil well). This allows the oil well owner to lock in a fixed sale price for oil that is expected to be produced at some point in the future.

Hedging is a way to transfer risk. Traders often use hedging to protect against risks when liquidating their trading position would be difficult or impossible. In the oil well example, the owner doesn’t wish to sell the oil well—just to reduce the uncertainty of his future earnings by locking in prices. Of course, this will remove the potential for additional profit along with limiting potential losses.

Hedging often involves both tradable and non-tradable investments. This creates accounting issues because the hedged item (like the crude oil that is expected to be produced) may not be valued the same way as the hedge (the futures). As a result, special accounting rules can be used to delay recognizing profits and losses of the hedge. This allows the trader to match the profit and loss reporting for the hedge (a tradable financial instrument) and hedged item (the non-tradable investment).

HEDGING

A hedge is an investment intended to offset potential ...