# Hedge

The hedging transaction (including hedging , currency hedging or hedge business called; English hedging "fence with hedges to protect against wind") is in the business a financial contract by which the price , exchange rate or interest rate risks from a received other risk positions are hedged should.

## General

Economic subjects ( companies , private households or the state with its subdivisions) take financial risks in many transactions . For example, if an exporter grants his importer a payment term in a foreign currency for deliveries , this exporter's claim is subject to both a payment risk and an exchange rate risk . While the payment risk can be transferred to an insurer by means of export credit insurance by passing on the risk , the exchange rate risk is assumed by credit institutions as a forward exchange transaction as part of risk reduction . The latter is a hedge transaction in the narrower sense and an offsetting transaction that hedges the risks from the underlying transaction (export).

Those involved in the hedge business are the “hedger” who is looking for protection and the counterparty ( trader or arbitrageure ) as counterparty , mostly credit institutions.

## Demarcation

Hedging is any measure “to hedge open capital positions exposed to a price risk by building up a counter position with a mirror-image risk profile”. The individual hedging transactions must actually serve to compensate for risks in order to be economically justified, because isolated hedging transactions are used for speculation and are not hedging. In the most favorable case, the counter-trades concluded are correlated with a correlation coefficient of negatively . ${\ displaystyle -1}$

## species

The specialist literature often restricts the hedge business to hedging foreign currency risks , but all market risks can be hedged. They result from changed external market data :

When hedging with options, there are still opportunities for profit from the underlying transaction, while futures are not expected to do so . With non-banks, country risks can be covered by export credit insurance and are therefore not part of the hedging transactions in the narrower sense.

A distinction is also made between micro-hedges and macro-hedges . Micro-hedges secure a specific underlying transaction, while macro-hedges secure entire portfolios . The latter is common with hedge funds .

A forward purchase to hedge price increases is called a long hedge , a corresponding forward sale to hedge against price drops is a short hedge .

## economic aspects

The hedge transaction is based on the intention of setting a price that is currently perceived as acceptable , such as the stock market price of a security , the exchange rate of a currency or an interest rate , for the future by means of risk compensation . Businesses that lead to inventories ( assets such as inventory or receivables and liabilities such as liabilities on the balance sheet ) are always threatened by a financial risk. The purchase price receivables from a domestic debtor, for example, are subject to a payment risk that is eliminated by credit insurance. If a company takes out foreign currency loans , these are subject to an exchange rate risk (the foreign currency in question could appreciate ) and an interest rate risk (the foreign currency interest rate could rise); both risks can be "hedged".

Protection is achieved by taking opposing, i.e. counterbalancing risks. In this way, the possible impairment is offset by the increase in value of the compensatory counter-position. A possibly necessary adjustment of a hedge is possible through delta hedging , depending on market developments . The perfect hedge ( English perfect hedge ) covers risks of a hedged item off completely, otherwise there is a residual risk ( english uncovered exposure ). A perfect hedge as a theoretical construct would eliminate any systematic risk . From an economic point of view, the hedging transaction is about the efficient allocation of risk .

A fair hedging transaction reduces the risks and potential returns of the hedged financial transaction to the same extent. In addition, additional transaction costs can arise for the hedging business . It is therefore not sensible to “hedge” every transaction. There is always a compromise to be found between expected return and acceptable risk . In general, hedging is uneconomical if the additional hedging costs are higher than the expected return on the financial transaction to be hedged.

In addition, hedging transactions on the futures markets is a complex process and associated with additional risks for inexperienced users. An example from the past is the large loss of Metallgesellschaft (today GEA Group ), which arose from a lack of understanding about hedging positions entered into in the oil futures business.

An alternative to hedging can be to reduce the volatility of a securities portfolio through diversification ( risk diversification ).

Transactions with mutual hedging are possible, in which both contractual partners benefit from the opposite development of a price - a classic " win-win situation". For example, a raw material producer and a raw material buyer can hedge each other with the help of a futures contract: If the raw material price falls, this means a loss of profit for the producer and is cheap for the buyer; if the price rises, the reverse is true. Through the securities transaction, the parties can insure themselves a fixed price, so that both the chance of additional profit and the risk of loss are limited to the same extent. Similar mutual hedging is also conceivable in the case of exchange rate risks, for example if the buyer and seller of goods are based in different countries. The organization of such a transaction using an exchange-traded security such as a future makes it easier to find a contractual partner and conclude the contract at low cost.

However, pure speculation with the aim of making a profit is also possible using the same instruments that serve to hedge risks . A large proportion of the derivatives traded on the stock exchanges are used for speculation. This can skew pricing and lead to speculative bubbles .

Critics of hedging argue that the risk being hedged will be passed and it would definitely take a partner ultimately ( English hot potato trading ). In addition, hedging transactions would help to inflate the cycles on the financial markets and would become independent of the real economy .