Detailed Glossary

A Detailed Glossary of Energy Trading terms for registered users

Browse the glossary using this index

A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z | ALL




by Nick Henfrey - Thursday, 26 March 2015, 7:23 AM

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


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)