HEDGING :Short hedge , Long hedge and Perfect hedging

What is hedging? Hedging techniques Short and Long hedge Perfect hedging Hedge fund

Hedge Hedgeable risks: is a position established in one market that attempt to offset the risk of any adverse price movement in an equal but opposite obligation or position in another market = insurance against negative event Hedgeable risks: - Price risks - Equity risk - Securities lending risk -Credit risk - Interest rate risk - Currency risk etc..,

Example: Hedging the Industry Risk in Stock Trading Assume: -A and B are the companies in the same industry =Their stock prices respond to industrial shocks in same direction. You believe that stock price of A company is undervalued currently To profit from this price change Long position on stock A (to buy A in the future at fixed price FA) To hedge against unfavorable price change due to industry risk Short position on stock B (to sell B in the future at fixed price FB)

Case 1: IF SA decreases (SB also decreases but by different amount) Loss from any adverse price movement in A will be offset by the gain from B. *Hedging reduces risk of loss* Case 2: IF SA increases as expected (SB also decreases but by different amount) Profit from the long position on A will partly offset by the loss from the stock B *Hedging reduces potential profit*

Hedging Types Financial instruments known as derivatives such as options and futures “Pairs trade”- by trading on a pair of related securities Natural hedging: an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses Ex: Korean company that has an subsidiary in US borrows in the USD to finance its operations there: hedging against currency risk

Short hedge and Long hedge Protect against Current condition Hedging method Short hedge Decline in future price Has acquired the asset Or Bought it for future delivery Sell future contract (agrees to make delivery in predetermined price) Long hedge Increase in future price Will need the asset in future date but don’t have it now Buy future contract (agrees to accept delivery)

Perfect hedge What Does Perfect Hedge Mean? A position undertaken by an investor that would eliminate all market risk from a portfolio.  Perfect hedges: - Consists of positions that have100% inverse correlation - provides return equal to risk free rate - overall gain or loss would be 0 As such, the perfect hedge is rarely found.

Hedge Fund A hedge fund is an investment fund : - open to a limited range of wealthy investors - undertake a wider range of investment and trading activities than other investment funds - pays a performance fee to its investment manager Originally, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. Nowadays, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, including funds that uses short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

World’s Biggest Hedge Funds by asset under management (9,March,2009)

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