Hedging: what it is and how is it used in finance
7 min read
A few years ago, even if I had a degree in Finance, I started thinking about how I should invest my money and the financial markets seemed really scary. First of all the choice was huge: how would I pick the right fund, the right company or the right product? Second, how could I evaluate every product in the market correctly for its risk, especially because many financial products are exposed to more than one risk?
Different types of risks can occur simultaneously and are the ones that affect the investment value of your financial instrument.
This is the risk you are taking towards the company that is issuing the product. You have to understand that this risk is mitigated. In Oval for example, the Issuer is dependent upon Cirdan, as Guarantor, to meet its payment obligations under the Certificates. Should the Guarantor fail to pay interest on or repay any deposit made by the Issuer or meet its commitment under a hedging arrangement in a timely fashion, this will have a material adverse effect on the ability of the Issuer to fulfil its obligations under Certificates issued under the programme.
Liquidity risk is the risk of not being able to buy or sell an asset quickly. The liquidity of a financial instrument depends on where it can be bought or sold (its market) but also on how often it gets traded. For example, a house has much more liquidity risk than a share of Apple. For the former, you need to wait for a buyer and go through a full transaction period, whilst you can sell the latter on the stock exchange in minutes. On Oval, your products can be sold on a business day so the liquidity risk is quite low.
Currency risk exists when you buy a financial instrument that is priced in a different currency from your own local currency. This means that if you buy Apple shares (that are in dollars) with your Euros, if the USD/EUR exchange changes you might make or lose money even if the asset itself does not change in price.
Volatility risk is the risk mainly associated with the movement in price of a financial instrument. For example, volatility is usually higher for shares of certain companies that can change their value very quickly, while financial assets like fixed rate products are generally less volatile since you know exactly the capital you will receive back after a given timeframe.
Interest rate risk
Interest rate risk is generally linked to movement in interest rates. These can change the value of a financial instrument, usually fixed income ones like bonds, as the value falls if the interest increases. With a higher interest rate, newer bond issues which reflect this change would be more attractive than those already on the market thus causing bond prices to fall.
Inflation risk happens if the return on investment is lower than the inflation rate, and it is amplified if you do not invest at all. Bonds are an investment that is most vulnerable to inflationary risk. This is because the fixed coupons do not take into account the possibility of higher inflation, meaning that with the same amount of money you can buy less goods.
When you select your investments you should always think about these risks and which ones you are willing to take more or less of. Once you have identified which ones you are willing to take, the best tool to mitigate some of the risks outlined above is called hedging. Hedging is usually used to protect an investment from one or more risks, by giving an investment less potential downside, but therefore reducing some of its potential upside (everything comes at a cost!).
Hedging should be thought of as an insurance. As with insurance, you choose to protect yourself against specific risks. So you should think of hedging in a similar way. If you think about the risks summarised above, I will outline some of the most common hedging tools. Many of these tools are other financial instruments, or most commonly derivatives, so you should be careful to understand how they work before using them.
Counterparty risk will never be completely eliminated but you can try to have less risk by spreading your investments across different players on the market. In Oval, with SmartETN, we have created a structure that reduces counterparty risk because the company can only buy the same assets as you are investing in, making it harder for the company to default. When you buy shares of a single company you have counterparty risk that the company could default or fail so you should think of diversifying your investments across many different companies. This is why we have launched Stock Bits and will add more companies in the future.
Liquidity risk can be avoided by choosing to invest in assets that you can sell when you need to. If you really do want to invest in buying a house, choose a location where houses have sold relatively quickly in the past to reduce this risk. Also, investing in startups or private equity generally carries a lot more liquidity risk because you have to wait for a liquidity event, a sale or initial public offering, before you can sell your investment.
Currency risk can be avoided by selecting to invest in products that are currency hedged. This is for example Stock Bits on Oval. You buy the shares of Tesla in Euro but you receive the price movement of the actual company, without the effect of the EUR/USD exchange rate.
This means that if you buy €100 of Tesla, when the EUR/USD is 1.2 and Tesla increases in value by 20% in a year, at the end of the year you will get exactly €120, even if the EUR/USD moves to 1.4. If you did not have the hedge you would have to exchange €100 into $120, and buy Tesla shares. If the share price increases by 20%, this means you would have $144, but to exchange back to Euros at the new exchange of 1.4 means you actually receive $144/1.4 = €103 . You would lose about €17 from your profit.
Companies can hedge this currency risk for you by buying a derivative called a swap. With a swap, the investment manager sets the price at which it wants to exchange euro for dollar at a future date, thus it does not matter if the price moves as it has already agreed on a fixed price. This is how SmartETN manages the currency risk for your investments.
Volatility risk happens when the price of a financial instrument moves up and down and is unpredictable. There are three ways to hedge the risk, some in part, some fully:
- The first is to diversify your portfolio. Each index and share of a company moves differently and depending on their correlation will move in diverging ways. For example, the price of Gold usually goes up when the stock market goes down. If you hold both gold and stocks, you are hedging the risk of your investment portfolio losing value.
- Secondly, you can hedge by investing with a cost-averaging mechanism. This means you invest a little every week. This smoothens the price movements and you will have obtained a lower volatility than by investing only one time.
- Lastly, to hedge your risk of the stock or index losing value you can hedge by buying a derivative called an option. A put option will allow you to sell shares of a company always at a pre-fixed price, the strike price. When you buy an option you can choose to exercise it or not. If you do not use it you will have lost just the price to buy it just like insurance. This means that if you own the company shares and a put option you will protect your investment. Read more about options here.
Interest rate risk can be hedged by swapping floating for fixed rate interest. Let's say you have a bond that pays you floating interest at EURIBOR + 3%.
EURIBOR is the interest rate for the Eurozone at which European banks lend to each other. A floating interest rate is an interest rate that moves up and down with the market or an index. It can also be referred to as a variable interest rate because it can vary over the duration of the bond. This contrasts with a fixed interest rate, in which the interest rate of the bond stays constant during its duration.
This interest changes every day and thus carries some risk. Today EURIBOR is negative at about -0.5%. This means your bond would pay today 2.5% in a year. To avoid the risk that this amount changes over time, you can choose to swap this rate for a fixed interest of say 2.5%. This means that if EURIBOR goes to 1% you will still get 2.5% instead of 4%, but if EURIBOR goes to -1%, you will still get 2.5%, instead of 2%. This hedge is for people that want to be sure exactly how much interest they receive on their investment just like buying a Fixed Rate on Oval.
Finally, to hedge inflation risk it is important to choose investments that give you a return greater than the inflation rate in your country. Inflation hedging is usually done through equity investments in indexes that track the market, since the market usually moves with inflation. The most common hedge for inflation though is investing in gold because if the currency loses value from the effects of inflation, gold tends to become more expensive. If you own gold, for example on Oval, you are therefore hedged from the falling value of your currency because the cost of gold will increase.
As you can see hedging has a lot of advantages but it can be hard to do on your own. This is why in Oval we design products that can mitigate some of the risks outlined above and we work to provide you with all the tools that allow you to make informed decisions.
Oval Marketplace does not provide investment advice and individual investors should make their own decisions. Seek the advice of a financial consultant if you are not sure about your investment. Your capital is at risk and the value of investments can go up as well as down and you may receive back less than your original investment: you should not invest money that you can’t afford to lose.