The Basics of Hedging Investments in New Zealand
Understand hedging thoroughly with our guide. We outline what hedging is, its benefits, mechanics, types, steps to hedge an investment in New Zealand, derivatives, expenses, key information and frequently asked answered questions.
Updated 8 August 2024
Summary
Our guide covers:
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Summary
- With the ongoing volatility in financial market, many New Zealanders look for ways to mitigate their downside risk and try to reduce the ongoing volatility in their portfolios.
- One of the key ways that typical investment managers improve their returns and cap their downside risk is to hedge their positions.
- Hedging as a risk management strategy can be useful for New Zealand investors looking to offset potential losses from adverse changes in share prices. However, it's important to understand the risks involved before entering into any derivative transaction.
- Derivatives can be extremely complicated and lead investors to take on significantly more risk than they otherwise would be exposed to if they were just buying shares.
- Additionally, investors should consider all the costs of hedging before deciding whether or not to hedge their investments. While hedging can be a useful tool for investors who want to protect their portfolios against losses, lock in profits, or speculate on the future direction of the market, it's important to understand that hedging comes with a cost which includes the "premium" for the derivative contract, opportunity cost, and the risk that the hedging strategy could fail.
- However, when used correctly, hedging can be a valuable tool for managing risk in an investment portfolio.
Our guide covers:
- What is Hedging, and Why Would I Want to Hedge My Investments?
- How do Hedges Work Mechanically, What are the Main Types of Hedges and How Can I Hedge My Investments in New Zealand?
- What are Some Common Examples of Derivatives in Action?
- What are the Costs Associated with Hedging?
- Must-Know Facts
- Frequently Asked Questions
Looking for related guides? We publish a range of hedging-related resources:
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Your investor guide to Hedging Investments is sponsored by our friends at Kernel, a platform that offers a range of investment products (including a selection of hedged funds) and innovative technology to grow your wealth with ease and all in one place.
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What is Hedging?
Hedging is a risk management strategy implemented by investors to minimise or offset the chance of loss from adverse price changes in the underlying asset. In other words, hedging protects investors from market volatility. There are many different ways to hedge an investment, but the most common methods involve using derivative contracts like options or futures. Derivatives are financial instruments that get their value from underlying assets (such as stocks, bonds or currencies).
An example using put options to hedge losses in the sharemarket:
An example using put options to hedge losses in the sharemarket:
- For example, let's say you own shares in a listed company that is extremely volatile in the stock market. You could buy put options on those shares to hedge your investment and reduce the volatility you might experience when investing in the stock.
- Put options give you the right (not the obligation) to sell your shares at a specific price within a certain period.
- Then, if the stock price drops below the put option's strike price (the price at which your option becomes active), you can "exercise" your option (trigger the derivative) and sell your shares at the higher price, limiting your loss.
Why would I want to hedge my investments?
There are several reasons why Kiwis might choose to hedge their investments:
1. Protect against losses
The most common reason is to protect against losses in a market downturn. By hedging their investments, investors can limit their downside risk and avoid the potential for large losses.
2. Lock in profits
Another reason to hedge your bets is to lock in profits on an increased value investment. For example, if you own stock in a company that has seen its stock price increase significantly (like Tesla in 2020), you could buy put options to lock in those profits in case the stock price falls in the future whilst still holding your Tesla stock.
3. Speculate on stocks/markets going up
Additionally, some investors use hedging as a way to speculate on the future direction of a stock or market. For example, by taking a position in both the underlying asset (such as buying Tesla stock) and a derivative contract (such as buying a Tesla call option), investors can make significantly more profit if their predictions are correct than if they had just purchased the stock. This outcome is why derivatives can result in a leveraged position, meaning your gains and losses are amplified.
I often hear hedging is used for foreign shares and funds. How does this work?
New Zealand fund managers often use hedging to protect investors from gains (and falls) in the NZD. Hedging in foreign exchange (FX) reduces the risk associated with currency fluctuations.
When an investor is exposed to a foreign currency (as is the case of holding a non-NZD fund or share), they are exposed to the risk that the value of that currency will decrease relative to the NZ Dollar. Hedging in FX involves taking a position in the FX market that offsets this exposure.
For example, an investor with a long-term investment in US shares may hedge their currency exposure by purchasing a currency forward contract for NZD and USD. This contract locks in a future exchange rate at which the investor can exchange their USD for NZD, reducing the impact of any adverse movements in the currency exchange rate.
Another way to hedge FX exposure is through the use of currency options.
Know This: Most New Zealand retail investors don't hedge their overseas shares, but you may see a fund's title include the word "hedged" or "unhedged", which distinguishes how the FX risk is addressed.
When an investor is exposed to a foreign currency (as is the case of holding a non-NZD fund or share), they are exposed to the risk that the value of that currency will decrease relative to the NZ Dollar. Hedging in FX involves taking a position in the FX market that offsets this exposure.
For example, an investor with a long-term investment in US shares may hedge their currency exposure by purchasing a currency forward contract for NZD and USD. This contract locks in a future exchange rate at which the investor can exchange their USD for NZD, reducing the impact of any adverse movements in the currency exchange rate.
Another way to hedge FX exposure is through the use of currency options.
- A currency call option provides the buyer with the option to purchase a specific currency at a predetermined exchange rate, but they are not obligated to do so.
- On the other hand, a currency put option grants the buyer the right to sell a specific currency at a set exchange rate, but they are not required to exercise this option.
- Both options allow the investor to limit their downside risk in adverse currency movements.
Know This: Most New Zealand retail investors don't hedge their overseas shares, but you may see a fund's title include the word "hedged" or "unhedged", which distinguishes how the FX risk is addressed.
How do Hedges Work Mechanically?
- Hedges transfer the risk of a share price's fluctuations (related to an asset) from one party to another.
- For example, imagine you're a farmer in Waikato and have just harvested your crop of apples. You may be worried that the price of apples might fall before you're able to sell them, so you decide to hedge your position by entering into a short hedge with a supermarket in Auckland.
- This scenario means that you will sell a futures contract for apples today and agree to deliver the apples (at a set price) in the future. By doing this, you've effectively locked in the sale of your apples at the current price and have transferred the price risk of your apples to someone else (the party on the other side of the transaction).
- On the other hand, suppose the price of apples falls by 40% due to a huge oversupply of imported apples. In that case, you will have mitigated this risk as your futures contract is locked in, and the other party (in this case, the supermarket in Auckland) has already committed to purchasing a certain number of apples from you at a set price.
Know This: Using a hedge can be both a good and a bad thing. Taking the example above, if the price of apples falls, you will still receive the agreed-upon price for your apples because you have locked in that price with your short hedge. However, if the price of apples rises, you'll miss out on profits because you've agreed to sell them at a reduced price than what they are currently worth.
What are the main types of hedges?
There are two main types of hedges:
- Short hedges: an investor buys a futures contract to sell an asset at a fixed/specific price at some point in the future. This type of hedge is used when the investor expects the asset price to fall.
- Long hedges: an investor sells a futures contract to buy an asset at a fixed/specific price at some point in the future. This type of hedge is used when the investor expects the asset price to rise.
How can I hedge my investments in New Zealand?
There are many different ways to hedge an investment, but the most common methods involve using derivative contracts like options or futures. Derivatives are financial instruments that get their value from the asset they're tracking or dealing with. Investing platforms that deal in derivatives will allow you to purchase these instruments. In New Zealand, the most popular platforms that offer derivatives are Interactive Brokers, BlackBull Markets, CMC Markets and Tiger Brokers.
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Your investor guide to Hedging Investments is sponsored by our friends at Kernel, a platform that offers a range of investment products (including a selection of hedged funds) and innovative technology to grow your wealth with ease and all in one place.
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What are Some Common Examples of Derivatives in Action?
Put Option Example
Generally, a put option is purchased to limit downside risk. For example, let's say you own shares in a company susceptible to volatile swings in the stock market. You could buy put options on those shares as a way to hedge your investment. Put options give you the right (not the obligation) to sell your shares at a specific price within a certain period. If the stock price drops below the put option's strike price, you can exercise your option and sell your shares at the higher price, limiting your loss. For more examples of options trading in New Zealand, check out our comprehensive guide here.
Call option example
Generally, a call option is purchased to capture upside risk (with limited upfront capital). Similarly, you could buy call options to hedge your investment. Call options give you the right (not the obligation) to purchase shares at a specific price within a certain period. If the stock price rises above the call option's strike price, you can exercise your option and buy shares at the lower price, locking in a profit. For more examples of options trading in New Zealand, check out our comprehensive guide here.
Short selling example
Generally, short selling involves profiting where a stock price declines in value. Short selling involves borrowing a security (a stock, bond or other instruments) and selling it on the open market to buy it back at a lower price and give it back to the original owner to profit when the price declines. For more elaborate examples, check out our comprehensive short-selling guide here.
Futures or swaps contracts examples
One final way to hedge investment is using futures contracts or swaps. Futures contracts are contractual agreements to buy/sell an asset at a fixed price on a future date. It's important to note that futures agreements are obligations (you are contractually obliged to execute the contract, you don't have a choice), unlike call or put contracts above where you have a right, not an obligation, to execute the contract. In contrast, swaps are agreements between two parties to exchange individual assets, such as cash flows from two different assets.
What are the Costs Associated with Hedging?
- Hedging comes with a cost, typically the "premium" (initial cost to write and establish the contract) paid for the derivative contract used to hedge the investment.
- For example, if you purchase a put option to hedge your investment, you'll have to pay a premium for that option. The cost of this "premium" can vary dramatically depending on the type of underlying asset you're trading, the appropriate amount of liquidity and volume on the trade and whether the option is "in the money" (meaning if you executed the contract or derivative, you would make a profit from it as it stands) or "out of the money" (meaning if you were to execute the contract, you wouldn't make a profit on it as it currently stands).
- The cost of hedging can also include the opportunity cost of not being able to profit from an increase in the underlying asset price. For example, if you purchase a put option to hedge your investment and the stock price rises, you'll miss out on the potential gains in share price from any increases in the asset price.
- Finally, there's always the risk that the hedging strategy doesn't work out as planned and ends up losing money. This outcome is particularly true for futures and swaps contracts.
- For example, using the earlier example, if you, as a supermarket in Auckland, expected the price of apples to increase in the next year. So you locked in the cost and quantity of apples by entering into a future contract with the apple grower from Waikato. Still, the price of apples plummeted, your hedging strategy has not worked out, and you will lose money (the difference between the price you locked in for the apples and the current price of the apples after the price has dropped) on each apple you purchased.
Hedging Must-Know Facts
1. Hedging is a risk management strategy to protect an investment from losses.
2. Common hedging strategies include buying put and call options, short selling, and using futures contracts or swaps.
3. The hedging costs include the premium for the derivative contract, opportunity cost, and the risk that the hedging strategy could fail.
4. Hedging can be useful for investors who want to protect their portfolios against losses or lock in profits.
5. Hedging is a double-edged sword.
- It is a strategy used to reduce or eliminate the financial impact of adverse price movements in the market.
- The main objective of hedging is to preserve wealth and minimize the risk of financial loss.
2. Common hedging strategies include buying put and call options, short selling, and using futures contracts or swaps.
- There are several common hedging strategies that investors use to protect their portfolios.
- One such strategy is buying put-and-call options, which give the buyer the right but not the obligation to sell or buy an underlying asset at a specific price.
- Short selling is another strategy where an investor sells a security they don't own to buy it back at a lower price.
- Futures contracts and swaps are derivatives that allow the buyer to speculate on an underlying asset's price movements, lock in profits, or reduce the risk of losses.
3. The hedging costs include the premium for the derivative contract, opportunity cost, and the risk that the hedging strategy could fail.
- Investors need to be aware of the associated costs before making any hedging decisions. The hedging costs include the premium for the derivative contract, opportunity cost, and the risk that the hedging strategy could fail.
- The premium is the cost of purchasing the derivative contract, which can be substantial, especially if the contract has a long lifespan.
- Opportunity cost refers to the potential profits the investor may miss out on by using funds to purchase the derivative contract. Finally, there is the risk that the hedging strategy may not work as planned, and the investor may still incur losses.
4. Hedging can be useful for investors who want to protect their portfolios against losses or lock in profits.
- As such, it's important to understand the associated costs before making any decisions. Hedging can provide stability and peace of mind, knowing that their investments are protected against market fluctuations. It can be useful for investors who want to protect their portfolios against losses or lock in profits.
- However, it's important to understand the associated costs and potential limitations before making any decisions.
5. Hedging is a double-edged sword.
- While it may mitigate your downside risk in some situations, it can also cap your upside risk.
- Hedging is a double-edged sword in that it can reduce the potential for losses and limit the potential for gains. While it may mitigate the downside risk in some situations, it can also cap the upside risk.
- This means that while hedging can protect an investment from losses, it can also limit the potential for profits.
Frequently Asked Questions
Who uses hedging?
Hedging is commonly used by institutional investors, portfolio managers, and hedge fund managers to reduce exposure to certain asset classes or industries and to mitigate downside risk. However, any investor can use hedging strategies to protect their portfolios, but this wasn't always the case.
Historically, it was extremely costly to hedge an investment portfolio and the types of investors who could access derivatives were very limited. However, with the recent democratisation of investment access and online tools offering more and more to their customers, it's never been easier to set up a brokerage account and get access to the derivatives market.
Historically, it was extremely costly to hedge an investment portfolio and the types of investors who could access derivatives were very limited. However, with the recent democratisation of investment access and online tools offering more and more to their customers, it's never been easier to set up a brokerage account and get access to the derivatives market.
What are some common hedging strategies?
Investors use the four most common hedging strategies: buying put options, selling call options, buying futures contracts, and short selling.
What is the difference between a short hedge and a long hedge?
A short hedge is used when the investor expects the asset price to fall. Conversely, a long hedge is used when the investor expects the asset price to rise.
How much does it cost to hedge?
The cost of hedging depends on the type of hedge used and the current market conditions. Additionally, the cost of premiums on derivatives contracts can vary widely depending on your investment platform. For a comprehensive comparison of the investment platforms in New Zealand, check out our definitive guide here.
What are some common types of risks that are typically hedged?
The most common risks that are usually hedged include the following:
- Interest rate risk (the risk that increases or decreases in interest rates hurt an underlying asset's value)
- Currency risk (the risk that increases or decreases in the strength of one currency hurt another currency or cash flows related to an underlying asset's value)
- Commodity price risk (the risk that increases or decreases in the price of a specific commodity, like oil or gold, hurts an underlying asset's value)
What’s the difference between hedging and insurance?
Hedging is a financial transaction used to offset potential losses from adverse price changes (usually through derivatives). Insurance is a contract that protects an individual or business from losses that may occur in the future.
What’s the difference between hedging and speculation?
Hedging is a financial transaction that offsets potential losses from adverse price changes. Speculation is defined as buying assets to profit from their future price movements.
What’s the difference between hedging and arbitrage?
Hedging is a financial transaction that offsets potential losses from adverse price changes. Arbitrage is buying and selling assets in different markets to profit from the price differences.
What is the difference between hedging and investing?
Hedging is a financial transaction intended to offset potential losses from adverse price changes. Investing is buying assets to hold them for future appreciation or income.
What are the main derivatives contracts that people use to hedge?
Hedges are purchased depending on your specific needs and objectives. Some common hedges include:
- Forward contracts
- Futures contracts
- Options contracts
- Swaps contracts
How can I get access to derivatives in New Zealand?
There are a few ways to access derivatives in New Zealand. One way is to trade them on the NZX Derivatives Market. This market offers various derivative products that are purchased for hedging purposes.
Another way to access derivatives is through some financial institutions that deal in derivatives, like investment banks (Goldman Sachs, UBS, Jarden, Craigs Investment Partners) or brokers (such as Interactive Brokers, BlackBull Markets, CMC Markets and Tiger Brokers). Financial institutions typically offer a wider range of products than the NZX, but they'll generally be more costly to trade.
Another way to access derivatives is through some financial institutions that deal in derivatives, like investment banks (Goldman Sachs, UBS, Jarden, Craigs Investment Partners) or brokers (such as Interactive Brokers, BlackBull Markets, CMC Markets and Tiger Brokers). Financial institutions typically offer a wider range of products than the NZX, but they'll generally be more costly to trade.
What should I weigh up before entering into a derivative transaction?
Before entering any financial transaction, it is important to understand the risks involved. This statement is especially true for derivatives since they are complex instruments with potential large losses. Some top things to consider before entering into a derivative transaction include the following:
If you're not comfortable with the risks involved in derivatives, other options may be more suitable for you.
- Your investment objectives
- Your risk tolerance
- The type of derivative you’re considering purchasing
- The costs involved
- The potential loss you may incur (with simple stock purchases, you can only lose as much as you put in. However, with derivatives, your losses can theoretically be infinite).
If you're not comfortable with the risks involved in derivatives, other options may be more suitable for you.
What are the best New Zealand investment platforms to hedge my investments?
The four main platforms in New Zealand that provide hedging options through derivatives contracts include:
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Your investor guide to Hedging Investments is sponsored by our friends at Kernel, a platform that offers a range of investment products (including a selection of hedged funds) and innovative technology to grow your wealth with ease and all in one place.
|
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