Hedging is generally known as a way to reduce risk, but for some investors, business managers and asset managers, it can actually increase certain kinds of risk. An effective hedge is one that goes up in value when the underlying asset goes down in value, and vice versa, but there are several ways to get a bad deal on the underlying hedge, get a hedge that doesn't account for the right risk or even hedge the wrong variable.
Hedging in General
In general, hedging is a simple process. An investor determines certain risks that exist in his portfolio, and makes trades that offset those risks. For example, an investor optimistic about energy might buy energy stocks in unstable countries, but then worry about a coup. To hedge the risk of a coup, this investor could bet against the sovereign debt of the country. A simpler hedge might involve deciding in advance how much downside risk to take. This requires buying put options that limit downside risk. They are essentially a one-time insurance premium that prevents further losses.
One of the biggest risks in hedging is the risk of overpaying. This often happens to investors who buy put options. Since a put option is priced at the point where it is expected to provide an equally good deal to buyers and sellers, this point can fluctuate based on investor sentiment or market events. During a market crash, the cost of this insurance rises, even if the underlying risks have not risen. An investor should consider the cost of the put option as part of the downside she is insuring against. If puts are too expensive, a smaller position in the underlying stock may be a better choice.
Some hedges are inexact. In the example above, an investor might bet against sovereign debt in order to hedge a position in a local company. While it's true that there are cases when sovereign debt would go to zero for the same reason that a local equity would, there are also cases where the opposite could happen. For example, a new government might elect to pay off a country's debt once and for all, by nationalizing local businesses. This would raise the price of debt and lower the price of equities, causing both sides of the trade to lose value.
Hedging the Wrong Variable
Investors who hedge will not always pick the right variable to hedge against. An investor may own an oil and gas company and bet that the price of oil will fall as a hedge, only to find out that the company's main asset is gas. This is different from an inexact hedge, and might be more properly termed an incorrect hedge.
Hedges as Bets
A hedged position is itself a position, and that position is subject to the usual rules. For example, buying an oil exploration company and betting against oil prices is basically a pure bet on the company's management. While this bet can pay off, there are cases where a company has poor management but good returns, simply because of the assets they own. If the value of those assets is hedged away, an investor can also hedge away the only profits he would have earned.
- Isolated hedge image by Pamela Uyttendaele from Fotolia.com