A hedger is a person or a fund that hedges, basically. A hedge can be defined as protection against financial losses in the future. There are so many financial products that help hedge against any kind of financial loss.
For example, a fund can hedge against inflation, which will reduce the value of the cash holdings, by buying commodities such as gold. Since gold is considered a natural hedge against inflation.
So, basically, a hedge is a protection tool and the person who uses these tools are called a hedge. Insurance can also be said to be a type of hedge.
If you think that a currency, say Euro, would lose its value against the Dollar, so you would buy the dollar and sell Euros.
This is the way you have hedged yourself against any losses that may arise due to a decrease in the value of the Euro in the future relative to the U.S. Dollar.
Hedge has been a tool, used since ancient times by investors to protect their investments against any expected losses.
In ancient times, the tools were simple, like buying gold or land which is an effective hedge against inflation. But, in our times, these tools have become much more sophisticated.
You can now hedge against prices of stocks falling or government bonds yield falling and consumer not paying their car loans and so on. There is a hedge against any type of financial loss.
Types of Hedgers
There are four main types of Hedgers. The four types of hedgers are classified based on the types of financial assets they largely hedge against. All four types of hedgers are given in figure 1.
Figure 1: Four types of Hedgers
The four types of hedgers based on the types of financial products they hedge against are Currency hedgers, stocks hedgers, corporate bonds hedgers and government bonds hedgers.
These are the hedgers who hedge against currencies. They use a number of financial tools to help hedge against a particular currency. They can buy put options, which allow the buyer of the put option to sell the currency in the future at an agreed-upon price.
This means that the hedger is expecting the currency would go down and by selling at an agreed-upon price, the hedger can make the profit by pocketing the difference between the high price and low price of the currency.
The put options are not used a lot in currency hedging. What most investors do is that they either buy another currency, like the U.S. Dollar against the currency which they expect to fall, like Euros.
The hedgers may also buy gold if there is an inflation risk associated with that particular currency. They may also buy insurance products against the currency.
Stock hedgers are those investors who hedge against a particular stock or even the whole stock market.
This is how Bill Ackman made Billions on a hedge bet just before the start of the Covid-19 pandemic, as he believed the stocks are overvalued. The hedge bet only cost him four or five million U.S. Dollars and he made billions of U.S. Dollars on the bet.
There are two most widely used tools used by stock hedgers. One is the call option, which allows the buyer of a call option to buy the stock of the company that the predetermined price in the future.
This means that the hedger believes that the stock would increase in value. The call option is the opposite of the put option. The put option has been explained in the currency hedging.
The stock hedgers may also hedge against a particular sector of the economy by hedging against a stock that operates in that part of the economy.
For example, a hedger may buy a put option in a mining stock because the hedger believes that the commodity prices would fall and as a result, the mining stock would also fall.
Corporate bonds hedgers
Corporate bonds hedgers hedge against corporate bonds. For hedging against corporate bonds, the hedgers use complicated financial products called swaps.
Swaps are like insurance on the corporate bonds and these contracts payout when the corporate bonds deteriorate in value.
Corporate bond hedging is on the high during the ending of a business cycle.
This is because the end of a business cycle means that the economy is about to enter into a recession due to the tightening of the credit.
This will especially affect the businesses that operate in a highly cyclical business. It means that these businesses would not be able to pay their debt obligations, or at the very least would have problems paying their debt due to the reduced cash flows associated with the recession in the economy.
So, the hedgers find this a great time to hedge against corporate bonds.
Government Bonds hedgers
The government bonds hedgers are cautious investors. They track the investment and credit cycle that have an impact on the government bonds.
The government bonds hedgers do not wait for the collapse of the government bonds, as the government is the most trusted borrower, and the chance of a government of a developed country defaulting on its loan is very very slim.
So, these hedgers target bonds of the emerging market, especially those governments which issue the bonds in foreign-denominated currency.
Argentina is a great example of this. It has defaulted multiple times on its foreign debt obligations. So, it is a great target for government bond hedgers.
Who are hedgers?
Hedgers can be said to be professional risk managers. They manage the risk for their clients by hedging against any foreseeable losses.
The hedge funds are associated with hedgers, but the hedge funds are not pure hedge plays. They also invest in stocks, bonds, and commodities. But, hedgers may be pure hedge play.
The hedgers are professional investment advisers that manage risks for their investors. Every hedger is a specialist in one type of hedging.
Hedging can be a great tool for managing any risk and for protecting your capital. The hedgers help you do that.