A hedge fund, like the term “hedging your bets” is a strategy for reducing risk. It aims to reduce investment risk while maintaining or increasing investment income, at the same time acknowledging the truism that “the higher the risk, the greater the return”. There are many variables and strategies in hedging, which is why management of hedge funds in the Cayman Islands is such big business.
Hedging is basically a form of insurance against negative events. It won’t prevent negative events, but if an investment is properly hedged, the negative event’s impact is reduced in the same way that insurance on a home reduces the financial impact of a fire or flood on the homeowner.
But while insurance compensates for loss, minus whatever deductibles are in the insurance contract, hedging an investment portfolio is not a simple matter of paying a fee every month for protection. Investors need to hedge one investment by trading in another to counterbalance.
Knowing how hedging works can help you understand how and why large corporations and investment funds use hedge funds to reduce risk and increase profit. The most common way of doing this is via financial instruments known as derivatives, usually options and futures. The goal being that a loss in an investment is counterbalanced, or offset, by gains in the derivative.
At its simplest, an options contract (usually representing 100 shares, with the buyer paying a fee, the premium, for each contract) allows an investor to buy or sell an asset at a stated price within a specified timeframe. Options give the investor a right, but not an obligation, to buy or sell. If the share price increases over the contract’s timeframe, the investor enjoys the profit in buying at the lower, earlier price. If the share price drops and the investor does not exercise the option on the expiration date, he loses the initial premium fee he paid to the potential seller.
The risk inherent in an options contract is greater for the seller. While a buyer risks losing only the premium paid up front, the seller is exposed to much higher risk should the stock price rise, increasing the seller’s losses. Rules around derivatives and when options can be exercised are not the same in every market, which is why it’s important to first consult a professional, such as a company specializing in global funds management in the Cayman Islands.
As a simple example of how a futures derivative works as a hedge, imagine you’re a farmer planting wheat in the spring and selling the harvest in the autumn. In the six months between planting and harvesting you have to carry the risk that the market price of your wheat crop might drop below its current price, reducing your potential profit.
To offset that risk, you sell a six-month futures contract at the current price of wheat, a forward hedge. At harvest time in six months, If the price of wheat has dropped, you sell at the prevailing price and buy back the futures contract cheaper than you sold it, generating a profit from the difference between the two prices.
Conversely, if the price of wheat goes up during the growing season, you would sell your wheat at the prevailing harvest price while buying back the futures contract at a loss. Hedging has limited your losses, but also limited your gains.
All hedging strategies have associated costs. Most investors buy-and-hold investments, simply ignoring short-term fluctuations entirely and will never use a derivative contract. Managers of hedge funds in the Cayman Islands will tell you that every hedging strategy has an associated cost and the potential benefits need to justify the expense. The goal of hedging is not to make money, but protect from losses. At the end of the day, the cost of a hedge can’t be avoided.
Original Source: https://medium.com/@CaymanGuide/hedge-funds-the-basics-8b4f581e25f
