Think hedging is important only for the British gardeners and Warren Buffets of the world? Think again, because knowingly or not, you hedge all the time.
For example, say your dorm has an SYR this weekend. You really want to ask your crush, that dreamy guy from microbiology. We'll call him DM for short. He's smart, funny, athletic, etc. He'd be the perfect date.
The only problem is that you're not sure he'll say yes. Maybe he's going out of town, maybe he already volunteered to rescue abandoned puppies that night or maybe he's just not that into you. You really want to go to the dance and don't want to risk being left dateless. What do you do?
You hedge.
It's easiest to think of hedging like insurance against a specific event that could turn out either positively or negatively. Hedging reduces the impact of a negative event by removing some of the risk.
See, there's another guy. You two met sometime during Frosh-O weekend and texted for about three days before you placed him squarely in the friend zone. Since then the friendship has blossomed: you had a couple of classes together, he invites you to his dorm parties and you occasionally get lunch in the dining hall. You know he'd be a fun date, but he's just not DM. You ask FZ (friend zone) to be your backup date.
Now, if DM says yes, you get to go to the dance with him. If he says no, you still get to go with FZ. Although it seems like a win-win for you, there are costs to every hedge.
By asking FZ to be your backup you might have hurt his feelings. At the very least, he has to hold the evening free just in case you need him. Even if DM says yes, taking advantage of a friendship makes the success seem just a little less sweet.
This is an example of the risk return trade-off in hedging. The hedge that reduces the risk you will be left dateless also has a cost that reduces the satisfaction you get even if the event turns out positively (your return.)
Hedging is obviously used in the financial industry. Say you're thinking about investing in the pizza industry because you think all of the national pizza chains are undervalued in the market. You decide to buy shares of Domino's (DPZ) because you really like the garlic powder that they sprinkle on the crust, and you think there's a huge demand for chain artisan pizza despite the fact that that's an oxymoron. If the pizza market expands, you think DPZ will perform well.
But, what if you're wrong and the pizza market contracts? That's where hedging comes in. You don't want to create a perfect hedge by selling DPZ shares, because then you'll remove all of the risk as well as all of the reward. Instead, you want to short sell shares of a company similar to DPZ, perhaps a company in the same industry, so that you remove the risk of the industry tanking but still have the opportunity to reap the reward of DPZ rising.
You choose to short Papa John's (PZZA) because you just don't think that better ingredients make better pizza, and if the industry declines, then PZZA will decline the most.
If you're right, the pizza industry takes off, and both stocks rise, then you made money by buying DPZ and lost money by selling PZZA. If you're wrong, the pizza industry declines, and both stocks drop, then you lost money by buying DPZ and made money by shorting PZZA.
This is how hedge funds were originally designed to operate. They would go long (buy) stocks they thought would outperform the market and go short (sell) stocks they thought would under-perform. The idea was that regardless of whether the market went up or down, they would make money.
Nowadays, hedge funds have a variety of investment strategies, most of which utilize derivative instruments like options or futures to provide hedges. Alas, you can't buy a DM future for Saturday's SYR. There's just no market for dance dates.
Grace Concelman is a senior majoring in finance and philosophy. She can be reached at gconcelm@nd.edu
The views expressed in this column are those of the author and not necessarily those of The Observer.
