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Hedge | ||
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To hedge is to offset, mitigate or reduce a risk or risks of an organization or individual by entering into contracts or trades A hedge is a trade or contract intended at least partly to reduce risk In Energy Trading the risk is usually market risk associated with other trades or contracts, or the operation of assets Detail Let's consider a very simple example Our organization buys oil for delivery next year, because it believes the price next year will be less than the strike price (the price we will pay for it). We're taking a risk we understand. But the strike price is in US Dollars (USD) so shortly after the delivery takes place we will have to pay for the delivery in USD (or the equivalent in another currency at the delivery time) We operate in GBP, but we don't know what the GBP price will be until delivery - so there is a risk the USD/GBP FX rate will move against us before delivery We call this risk FX exposure to US dollars We're not interested in currency speculation, so we buy the required USD now at the forward FX rate Now we have no risk associated with FX exposure We have hedged our FX exposure Hedging is usually carried out with Derivatives. In our example above we could have bought the dollars immediately, but then we would be exposed to the USD interest rates, so it's more likely we would hedge with a Forward contract or a Futures contract Hedging is frequently carried out with financially settled instruments: the profit or loss we make on the hedge offsets any additional cost of the physical trade See also Hedge Accounting and Delta Hedging which are related Another useful way to think of a hedge is a means of realizing a profit-making strategy (profit-making strategies invariably being associated with risk!). If we think we will make a profit bidding on capacity through a pipeline, then the hedges would be the deals to buy at the cheaper location and sell at the more expensive location By this extension we can also say that hedging a position is a way of saying flattening the position (for example of a book) by trading the position to somewhere else (for example another book, or externally) | ||