Examples Hedge (finance)

1 examples

1.1 agricultural commodity price hedging
1.2 hedging stock price
1.3 stock/futures hedging
1.4 hedging employee stock options
1.5 hedging fuel consumption
1.6 hedging emotions

examples
agricultural commodity price hedging

a typical hedger might commercial farmer. market values of wheat , other crops fluctuate supply , demand them vary, occasional large moves in either direction. based on current prices , forecast levels @ harvest time, farmer might decide planting wheat idea 1 season, price of wheat might change on time. once farmer plants wheat, committed entire growing season. if actual price of wheat rises between planting , harvest, farmer stands make lot of unexpected money, if actual price drops harvest time, going lose invested money.

due uncertainty of future supply , demand fluctuations, , price risk imposed on farmer, said farmer may use different financial transactions reduce, or hedge, risk. 1 such transaction use of forward contracts. forward contracts mutual agreements deliver amount of commodity @ date specified price , each contract unique buyer , seller. example, farmer can sell number of forward contracts equivalent amount of wheat expects harvest , lock in current price of wheat. once forward contracts expire, farmer harvest wheat , deliver buyer @ price agreed in forward contract. therefore, farmer has reduced risks fluctuations in market of wheat because has guaranteed number of bushels price. however, there still many risks associated type of hedge. example, if farmer has low yield year , harvests less amount specified in forward contracts, must purchase bushels elsewhere in order fill contract. becomes more of problem when lower yields affect entire wheat industry , price of wheat increases due supply , demand pressures. also, while farmer hedged of risks of price decrease away locking in price forward contract, gives right benefits of price increase. risk associated forward contract risk of default or renegotiation. forward contract locks in amount , price @ future date. because of that, there possibility buyer not pay amount required @ end of contract or buyer try renegotiate contract before expires.

future contracts way our farmer can hedge risk without few of risks forward contracts have. future contracts similar forward contracts except more standardized (i.e. each contract same quantity , date everyone). these contracts trade on exchanges , guaranteed through clearinghouses. clearinghouses ensure every contract honored , take opposite side of every contract. future contracts typically more liquid forward contracts , move market. because of this, farmer can minimize risk faces in future through selling of future contracts. future contracts differ forward contracts in delivery never happens. exchanges , clearinghouses allow buyer or seller leave contract , cash out. tying farmer selling wheat @ future date, sell short futures contracts amount predicts harvest protect against price decrease. current (spot) price of wheat , price of futures contracts wheat converge time gets closer delivery date, in order make money on hedge, farmer must close out position earlier then. on chance prices decrease in future, farmer make profit on short position in futures market offsets decrease in revenues spot market wheat. on other hand, if prices increase, farmer generate loss on futures market offset increase in revenues on spot market wheat. instead of agreeing sell wheat 1 person on set date, farmer buy , sell futures on exchange , sell wheat wherever wants once harvests it.

hedging stock price

a common hedging technique used in financial industry long/short equity technique.

a stock trader believes stock price of company rise on next month, due company s new , efficient method of producing widgets. wants buy company shares profit expected price increase, believes shares underpriced. company part of highly volatile widget industry. there risk of future event affects stock prices across whole industry, including stock of company along other companies.

since trader interested in specific company, rather entire industry, wants hedge out industry-related risk short selling equal value of shares company s direct, yet weaker competitor, company b.

the first day trader s portfolio is:

long 1,000 shares of company @ $1 each
short 500 shares of company b @ $2 each

the trader has sold short same value of shares (the value, number of shares × price, $1000 in both cases).

if trader able short sell asset price had mathematically defined relation company s stock price (for example put option on company shares), trade might riskless. in case, risk limited put option s premium.

on second day, favorable news story widgets industry published , value of widgets stock goes up. company a, however, because stronger company, increases 10%, while company b increases 5%:

long 1,000 shares of company @ $1.10 each: $100 gain
short 500 shares of company b @ $2.10 each: $50 loss (in short position, investor loses money when price goes up)

the trader might regret hedge on day two, since reduced profits on company position. on third day, unfavorable news story published health effects of widgets, , widgets stocks crash: 50% wiped off value of widgets industry in course of few hours. nevertheless, since company better company, suffers less 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 hedge, trader have lost $450 (or $900 if trader took $1,000 has used in short selling company b s shares buy company s shares well). hedge – short sale of company b net profit of $25 during dramatic market collapse.

stock/futures hedging

the introduction of stock market index futures has provided second means of hedging risk on single stock selling short market, opposed single or selection of stocks. futures highly fungible , cover wide variety of potential investments, makes them easier use trying find stock somehow represents opposite of selected investment. futures hedging used part of traditional long/short play.

hedging employee stock options

employee stock options (esos) securities issued company own executives , employees. these securities more volatile stocks. efficient way lower eso risk sell exchange traded calls and, lesser degree, buy puts. companies discourage hedging esos there no prohibition against it.

hedging fuel consumption

airlines use futures contracts , derivatives hedge exposure price of jet fuel. know must purchase jet fuel long want stay in business, , fuel prices notoriously volatile. using crude oil futures contracts hedge fuel requirements (and engaging in similar more complex derivatives transactions), southwest airlines able save large amount of money when buying fuel compared rival airlines when fuel prices in u.s. rose dramatically after 2003 iraq war , hurricane katrina.

hedging emotions

as emotion regulation strategy, people can bet against desired outcome. new england patriots fan, example, bet opponents win reduce negative emotions felt if team loses game. people typically not bet against desired outcomes important identity, due negative signal identity making such gamble entails. betting against team or political candidate, example, may signal you not committed them thought were.