eFinancialCareers

What is it?

Fundamentally, hedging is a way of reducing the risk that a particular investment will lose you money. Usually, it involves making another investment that will make money in the precise circumstances in which the original investment will make a loss.

In financial markets, hedging often involves buying a futures contract. This enables a buyer or seller to fix the price at which the financial product in question will be bought or sold in the future.

For example, a company that wants to sell oil in two years' time may buy a futures contract guaranteeing that it will be able to sell some of its oil at the price it aspires to. If the price has fallen, it will therefore have the right to sell above the market. A perfect hedge is one which cancels out the risk of loss entirely.

It’s worth bearing in mind that hedging a risk related to a particular product or security can involve buying a different thing entirely. For example, an investor in Widget Maker A might invest some of his money in its only rival, Widget Maker X. This way, he ensures that if X seizes market share from A, he’s still exposed to some upside.

What’s it got to do with the financial crisis?

Both banks and hedge funds have lost money because their hedging activities failed to foresee the extent of the collapse in prices for mortgage-related asset backed securities and other kinds of bets.

In October, for example, Citadel Investment Group saw its investors panic as word got out that the firm's bets in some areas were not fully hedged. The firm held a conference call -- which counted over 1,000 listeners -- to calm the markets about the firm's prospects for survival.

In June, Lehman Brothers said it lost $500m-$700m on some of its hedging positions.

The main problem was that mortgage backed securities were both difficult to hedge in the first place, and then behaved in strange ways once the market became stressed. Most investment banks had tried to hedge their risk to these securities by short selling the riskiest bits of products like CDOs to investors. At the same time, they kept the least risky bits for themselves.

The theory was that a fall in the price of the risky slices of CDO would be more than enough to offset any fall in the price of the less risky bits that banks were keeping for themselves.

Things didn't go to plan. Instead, the price of the less risky bits of CDO, which were owned by banks, crashed more than the risky slices. Banks were left severely out of pocket.

What made the price of the less risky bits crash so badly? Panic. As banks tried to sell their less risky products to investors, the market became flooded and the price crashed.

The least risky slices therefore became the most risky, and the hedge – which wasn’t very efficient to begin with – didn’t work at all.

Hedging drew a lot of attention in late 2008 and early 2009 as controversy erupted about Goldman Sachs's your link text hereexposure to the failing AIG. Goldman argued that it was fully hedged on its exposure to the failing AIG, but when the insurer fell, Goldman demanded all $13 billion it was owed; the only difference was that the government paid the consideration, instead of AIG.

Last updated on 7 September 2009.

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