Financial Hedging

Abstract

Calculating the presence of risks is but one part of investment strategy. Another important part is weighing the extent of those risks against the potential returns. For many market participants, such an analysis helps to gauge which investments are worth the risk and which ones should be avoided. For others, however, this calculation helps determine how much risk may be worth the potential returns, as well as what might be done to minimize the negative effects while experiencing a positive effect. At the core of this latter practice is the practice of financial hedging. As its name suggests, this term refers to placing investments within a framework that keeps losses to a minimum. This paper presents a careful analysis of the idea of financial hedging, how it is conducted, and the positive and negative aspects to such a practice. The reader gleans a better understanding of how this concept is utilized to protect the interests of the investor.

Overview

Winston Churchill once commented on what he saw as the benefits to a life of uncertainties. "Without a measureless and perpetual uncertainty," he said, "the drama of human life would be destroyed." In terms of investment practices, Churchill's statement certainly has validity. Indeed, much of market investment depends heavily on calculating risk and uncertainty in order to maximize returns and avoid loss.

Then again, calculating the presence of risks is but one part of investment strategy. Another important part is weighing the extent of those risks against the potential returns. For many market participants, such an analysis helps to gauge which investments are worth the risk and which ones should be avoided. For others, however, this calculation helps determine how much risk may be worth the potential returns, as well as what might be done to minimize the negative effects while experiencing a positive effect

At the core of this latter practice is the practice of financial hedging. As its name suggests, this term refers to placing investments within a framework that keeps losses to a minimum. This paper presents a careful analysis of the idea of financial hedging, how it is conducted and the positive and negative aspects to such a practice. The reader gleans a better understanding of how this concept is employed to protect the interests of the investor.

A Brief Overview of Hedging. There are countless factors within the vast series of networks which make up the capitalist market system that can impact, positively or negatively, a financial investment. For example, an American company that purchases a factory in China might see positive returns because of the strength of the US dollar against the Chinese yuan, but if that currency exchange rate falters, the return might be less than anticipated. Similarly, lending practices may be greatly enhanced by a federally-imposed reduction in interest rates, and conversely, leveled or increased interest rates may negatively impact the maturity of long-term investments.

Indeed, the financial world is affected by a myriad of influences, from inflation to war to weather. When a hurricane moves its way into the Gulf of Mexico, for example, its potential destructive force often causes oil companies to halt operations on off-shore oil drilling rigs. The lack of production in turn causes an increase in the average cost of fuel, which in turn impacts manufacturing facilities, transportation companies and the airline industry. Put simply, a storm located in one geographic region of the United States can send ripples across every sector of the American economy.

Because of these potential "flies in the ointment," investments always occur with risks. Of course, no investment can be perfectly sheltered from the elements. Still, some of the most critical but vulnerable corporate investments may be at least partially covered from such issues. In this regard, many investors, therefore, will seek to minimize these risks by entering into other investments or trade relationships that will properly frame the size of the return the investment will generate. In many cases, this is done by hedging the investment.

In 1949, Alfred Winslow Jones, who was a reporter for Fortune magazine, was researching an article about the latest in investment trends and market forecasting. During his study, he developed his own theories about how an investor might wisely direct his or her pursuits as well as how he or she might protect those investments from great risk. Jones raised $100,000, including $40,000 of his own money, to conduct a number of long-term market investments. However, this investment strategy included a set of short-term stock purchases and leveraged funds (borrowed money), which he added to his portfolio in order to offset risks to the long-term securities. Less than 20 years later, Jones's "hedge fund" was the top five-year mutual fund with an 85 percent return (Gabelli, 2000).

Derivatives. The practice of financial hedging varies in substance. In general, however, hedging in financial terms entails the use of derivatives that will offset the volatility of the investment. Derivatives are arrangements or contracts between two parties that are based on fluctuations and fluid conditions. The two most common types of derivatives are options and futures. An option is essentially a contract between an investment purchaser and seller whereby a security is bought based on the presumption that the value of the shares involved will either rise or fall compared to the agreed-upon price. The buyer will seek to purchase the share at a low point but believes that the shares will increase in value, while the seller will proceed from the idea that the stock price will fall compared to the agreed-upon price ("A beginner's guide to hedging," 2009). Under an option, the buyer is not under an obligation to buy or sell at a given price, but does reserve the right to do so.

The second type of derivative is a futures arrangement. Futures are contracts that arrange for the delivery of securities at a future date in exchange for a cash payment. Futures transactions occur within the framework of futures exchange markets, wherein the contracts are standardized (and not established by the parties themselves), performances are guaranteed by the market and gains and losses are carefully computed and managed by the exchange (Arditti, 1996). Because futures contracts create potential gains for the buyer but are carefully managed by a third party, they represent an effective tool by which financial hedging may occur.

Hedge Funds. Hedging may occur via hedge funds, which have since evolved from Alfred Jones's brainchild, or through other mechanisms. In many cases, an investor may imitate the classic hedge fund by investing 50 percent of his or her securities in a traditional long-term mutual fund (or more than one), and 50 percent in short-term mutual funds. Such 50-50 investment strategies have yielded an average return little more than 12 percent. Even during the bear market of 2002, an investment strategy along these lines might have included Prudent Bear, which saw a return rate of nearly 63 percent in 2000, and Meridean Growth Fund, which was experiencing the adverse impacts of a stagnant economy ("How to build your own hedge fund," 2005).

Financial hedging is an investment strategy designed to offset risks. While this financial pursuit would by its very definition suggest a positive return for the investor, there are positive and negative aspects to hedging. This paper will next turn to a study of the benefits and drawbacks of financial hedging.

The Benefits of Hedging. The list of financial hedging benefits begins with a point already discussed in this paper—the practice of hedging mitigates the risks of long-term investments. Hedge funds involve small investments that are less risky and provide significant returns—the aggregate of hedge fund securities therefore creates a cushion for investors whose larger interests rest in more volatile markets.

This lack of risk and promise of positive returns underscores another important benefit of hedging. In the stock market, investors must take into account the myriad of factors that may play a role in increasing or decreasing returns. During the course of investment strategy development, investors must also calculate the timing of entry into and exit from the market. Hedging, however, provides the potential for fewer risks and higher returns—as such, investors are fortunate to see a broader window of entry or exit from the markets.

Derivative markets became extremely popular among investors and, in particular, institutional investors in the late twentieth and early twenty-first century. Over a 15-year period, hedge fund investment increased dramatically, from less than $30 billion in 1990 to $1.2 trillion in 2005 (Center for International Securities and Derivatives Markets, 2006). Corporations, public pensions and bank trusts are among those who have increasingly sought the security of hedge fund trading. In addition to the reasons just described, observers offer a number of advantages to derivatives trading over cash market investments. According to a 2002 study, investors saw lower transaction costs, lower market impact costs and reasonably priced access to leverage. Hedge fund markets, the study added, offer greater security and government oversight, thereby preventing wild fluctuations that can adversely impact fund performance (Schneeweis, 2002).

Still, the diversity of the types of investments involved in hedge funds are flexible enough to entice a tremendous volume of financial players. For example, the world's largest hedge fund company in 2017, Bridgewater Associates, had $122 billion in assets under management. That fund caters largely to foreign governments, banks, educational institutions and nonprofit groups, and therefore spreads its ventures across a broad spectrum of non-aligned markets and instruments.

The Downside of Financial Hedging. As demonstrated in this paper, the diversity of hedge fund investing practices has proven beneficial for investors; giving them wide degrees of flexibility and, in most cases, reliable returns. Hedge markets are to a large degree well-protected, by both the nature of the investments and the fact that many of the investments are protected by government oversight. However, as the popularity of hedging and hedge funds has increased over recent years, markets and investment practices have diversified to the point where oversight and security has become stretched thin. Still, given the returns, both real and potential, expected through hedge fund investments, consumers showed willingness to put their monies into such funds, even if it meant higher fees, a lack of access to those monies and secretive investments.

In late 2008, Bernard Madoff, a Wall Street icon, appeared in front of his employees (including his sons, who had worked for him throughout their careers) and said that he had had enough. "It's all one big lie," he said, a statement his sons and other employees knew would have devastating implications. Madoff was admitting to the fact that his hedge fund, which involved at least $50 billion, was a fraud (Securities and Exchange Commission, 2008).

Madoff was considered a pioneer of the New York Stock Exchange. An investment innovator, he established deep roots in the Jewish philanthropic community and in networks around the globe. Madoff made sure to include such friends in his investments and, in light of his reputation and experience on Wall Street, made participation in his business opportunities unquestioned among clients. The fact that such investments consistently brought supposed returns of 15 percent annually regardless of market conditions made the attraction even stronger.

However, Madoff's hedge fund in fact had no substance. Instead, Madoff had concocted what is known as "Ponzi scheme"—Madoff would take client funds and invest them in what they thought was a vast network of opportunities but instead, when other clients would seek redemptions, he would simply transfer the money invested by others. With over 4,000 investors (the number of which was consistently growing, thanks to the aforementioned reputation Madoff held), Madoff was able to continue his pyramid scheme for many years without fear of the bubble bursting. In fact, although Madoff was under suspicion by a number of whistle-blowers nearly a decade earlier, they could not trace the monies.

When the market began turning for the negative in 2008, however, Madoff's clients increasingly sought redemptions (while new investor numbers shrank). With Madoff's hedge fund consistently losing money to transfer, he was backed into a corner and forced to confess to his crime (Lendman, 2008).

The Madoff case underscores a number of issues about the nature of hedging. Designed to create security for investors, hedge investing also presents risks. As demonstrated in the 2002 study discussed earlier in this paper, there is a measure of government oversight over hedging, but Madoff demonstrated that there are ways to avoid such oversight. Additionally, Madoff employed third-party agents to administer many of his transactions, adding a large degree of secrecy to the hedge fund. While the $50 billion (or more) Madoff mismanaged represented a fantastic crime, the fact is that many hedge funds employ a similar degree of secrecy and lack of access to investor monies. The recession that helped bring Madoff's crimes to light generated increased interest in more government oversight and safeguards regarding financial hedging and the returns such practices promise.

Efforts to Regulate Hedging Practices. Although hedging is not an option readily available to every citizen (certainly, millions of people simply cannot afford to pay the high fees associated with hedging), the fact that so many pension funds and personal retirement accounts have contact with hedge fund investors means that it is a financial sector whose influence is significant. When an incident like Madoff's arrest occurred, therefore, it cast a spotlight on hedging. The recession that began in 2008 added to the concern. In 2007, a presidential working group looking into regulatory measures governing financial hedging concluded that no further oversight was necessary. Foreshadowing the events that would occur a year later, however, the then-chairman of that commission called hedge funds a "dark corner" of the market and said that hedging was a central figure in a significant number of market trading abuse cases. A number of regulatory measures were introduced to govern who invested in hedge funds (based on their personal incomes) and to discourage risk-taking investments, but neither the commission nor Congress took any steps to make any major changes in this arena (Labaton, 2007). Two years later, a weak economy and more instances of hedge fund abuse powered calls for hedge fund licensure and direct regulations. In 2010, Congress passed the Dodd-Frank Wall Street Reform Act, which required hedge fund managers with more than $150 million in assets to register with the SEC and file regular reports about their trades and portfolios. Investment advisors with less then $100 million in assets became subject to state regulation. Furthermore, under Dodd-Frank, banks are required to limit their relationships with hedge funds (VanDenburgh, 2013).

Conclusion

Although a large population is unable to afford the high prices for investing in hedge funds, financial hedging has become an increasingly popular venture for those whose incomes and investment capabilities can support such activities. While hedging has been in practice since the end of the Second World War, the practice has truly taken flight over the last 30 years, coinciding with market fluctuations. In the 2010s, hedging consisted of some $3 trillion in assets.

As discussed in this paper, the reasons for increased interest in financial hedging are clear. Hedging offers the investor an opportunity to protect his or her assets in other markets. Long-term stock market investments, as shown in this essay, are easily impacted by a whole range of factors that may cause losses for the investor. Hedging presents reliable, short-term returns that can be used to offset such losses.

Of course, there are risks inherent in the practice of hedging. Much of these negative aspects have to do with the fact that hedging has grown exponentially over the last two decades, to the point where there are countless types of investments placed into hedge fund markets. It is this growth that has made oversight and security a challenge and created openings for illegal management of such investments.

The Bernard Madoff scandal caused the losses of tens of billions of dollars to investors around the world, although the true extent of the damages caused by one of the largest frauds in US history is difficult to calculate. This extraordinary incident, coupled with the accompanying economic downturn, led to an increased call among political leaders and industry experts for an overhaul of the way hedging is conducted. However, some question the effectiveness of these reforms, due in no small part to the fact that the industry's exponential growth has made full understanding of the breadth of financial hedging a challenge, one that cannot be easily mitigated even when the stakes are at their highest.

Terms & Concepts

Derivatives: Arrangements or contracts between two parties that are based on fluctuations and fluid conditions.

Futures: Contracts that arrange for the delivery of securities at a future date in exchange for a cash payment.

Hedge fund: A portfolio of short-term investments designed to create consistent returns that may be used to offset losses in other markets.

Option: Derivatives contract between an investment purchaser and seller whereby a security is bought based on the presumption that the value of the shares involved will either rise or fall as compared to the agreed-upon price.

Ponzi scheme: Pyramid scheme in which investor monies are transferred from one account to another in order to give the impression of a return on investment.

Bibliography

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Suggested Reading

Bodellini, M. (2017). From systemic risk to financial scandals: The shortcomings of U.S. hedge fund regulation. Brooklyn Journal of Corporate, Financial & Commercial Law, 11(2), 417-467. Retrieved February 15, 2018, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124218594&site=ehost-live&scope=site

Jacobius, A. (2009). Funds pour big money into realm of real assets. Pensions and Investments, 37, 30-33. Retrieved February 28, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36590313&site=ehost-live

Landis, D. (2009). Hedges that didn't get hosed. Kiplinger's Personal Finance, 63, 42-43. Retrieved February 28, 2009, from EBSCO online database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36414784&site=ehost-live

New hedge funds smaller in '08. (2009). American Banker, 174, 6. Retrieved February 28, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36629000&site=ehost-live

Temple-West, P. (2009, February 2). Proposed legislation to expand SEC role in hedge fund oversight. Bond Buyer, 367(33053), 4. Retrieved February 28, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36406709&site=ehost-live

Terzo, G. (2009). Re-starting a hedge fund? Investment Dealers' Digest, 75, 10-22. Retrieved February 28, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36094404&site=ehost-live