Hedging and arbitrage

Hedging is used by investors and business people as a risk management strategy that offsets or neutralizes potential losses from another investment. Hedging strategies are also referred to as Pairing Off, Pairs Trading and Long/Short strategies.

The History of Hedging

The concept of hedging can be better understood by comparing it to insurance. Insurance protects an item from a negative incident. An insured item will have reduced damages when struck by undesirable occurrences. 

The practice of hedging one’s bets traces its origin far beyond the existence of the modern day derivatives markets. Records of farmers hedging the value of their crops with forward contracts date as far back as 1750 B.C.

In his book Antifragile, Nassim Taleb recites the story of Thales of Miletus (624 – 546 BC), a philosopher, who corners the olive market by putting a down payment of all olive presses in the vicinity of Miletus. The downpayment, in this case, is effectively an option or a forward contract.

Sophisticated derivatives markets for commodities start to develop in Europe and the U.S. during the 16th century and equity derivatives are developed in New York in the late 18th century.

A.W. Jones & Co, the worlds first Hedge Fund is established by Alfred Winslow Jones in 1949. Although a much more general term today, the original hedge funds aimed at taking market neutral bets by applying leverage with long/short pairing trades. 

Hedging Methods

As far as hedging is concerned, investors need to hedge on what returns value. It is crucial to conduct an assessment to determine hedging programs that return value to the shareholders.

Various financial instruments are at disposal to anyone wishing to hedge a long exposure. These instruments, generalized as derivatives as they derive from an underlying asset, include:

  • Short selling of securities
  • Options
  • Futures
  • Forwards
  • Swaps

Options are commonly used by investors as it gives them the right to buy or sell a stock within a specified timeframe. In this stock scenario, an investor buys a stock. He or she pays a certain amount of money so that when the price of the stock comes down, they can sell it at the same price.

The investor would have minimized losses since the loss can only be felt by the small amount of fee paid. On the other hand, if the price of the stock increases, the profits will be slightly by the fee paid.

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