What Is a Micro-Hedge?
A micro-hedge is an investment technique used to eliminate the risk of a single asset from a larger portfolio. In most cases, a micro-hedge involves taking an offsetting position in that single asset. Offsetting positions can include taking short positions in similar shares, or options or futures contracts of that same asset.
Key Takeaways
- A micro-hedge involves minimizing the risk exposure of a single asset or component of a larger portfolio.
- Offsetting positions using similar securities or derivatives contracts listed on that stock can be used as a micro-hedge.
- A trader may want to engage in a micro-hedge if they are uncertain about a particular position but do not wish to dispose of the position altogether.
Understanding Micro-Hedging
A micro-hedge can reduce or eliminate the risk of one asset in a portfolio, but it will have little effect on the risk or the overall portfolio, unless the portfolio is highly concentrated. If this asset is part of a larger portfolio, the hedge will eliminate the risk of the one asset but will have less of an effect on the risk associated with the portfolio.
All investments are accompanied by various levels of risk. Investors create well-diversified portfolios of securities to effectively manage those risks. However, there are times when a single security within a portfolio can cause great concern. It could be because the security is a stock that is extremely costly, or because it is a security with a history of volatility. Whatever the case, a micro-hedge can be an effective way to deal with these securities.
Example of a Micro-Hedge
Say you are holding the stock of a company and want to eliminate the price risks associated with that stock. To offset your position in the company, you could take a short position by purchasing a put option on that single stock, thereby establishing a floor price for the period of the options contract. This strategy is used when an investor feels very uncertain about the future movement of a single asset.
A micro-hedge can also be created by purchasing additional securities that should move in opposite directions under the same conditions; for instance, a corporate bond against a share of stock in the same company. One problem, however, is that it is difficult to predict which direction securities will move under what conditions, and historical correlations are not necessarily a good indicator of future outcomes.
Micro-Hedges vs. Macro-Hedges
Micro-hedges can be contrasted with macro-hedges. A macro-hedge is an investment technique used to mitigate or eliminate downside systemic risk from a portfolio of assets. Macro-hedging strategies typically involve using derivatives to take short positions on broad market catalysts that can negatively affect the performance of a portfolio or a specific underlying asset.
The "macro" in macro-hedge refers to risk mitigation around macroeconomic events. Therefore, macro-hedging generally requires significant foresight, extensive access to economic data, and superior forecasting skills to project the expected reaction of markets and investment securities when trends occur. However, in some cases, macro-hedging positions may be easily foreseen by a series of events leading to a predetermined outcome.
FAQs
This strategy is used when an investor feels very uncertain about the future movement of a single asset. A micro-hedge can also be created by purchasing additional securities that should move in opposite directions under the same conditions; for instance, a corporate bond against a share of stock in the same company.
What is hedging with an example? ›
Hedging is recognizing the dangers that come with every investment and choosing to be protected from any untoward event that can impact one's finances. One clear example of this is getting car insurance. In the event of a car accident, the insurance policy will shoulder at least part of the repair costs.
What is an example of a hedging approach? ›
In practice, hedging occurs almost everywhere. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks.
What are hedging activities examples? ›
Some common examples of hedging are using derivatives such as options or futures to mitigate losses, buying an insurance policy against property losses, etc.
What is the difference between a micro hedge and a macro hedge? ›
Answer and Explanation:
An FI in Micro Hedging is used to hedge a specific asset or liability risk or value. An FI in Macro Hedging is used to hedge an entire balance sheet's value or the entire duration gap of an FI.
How to make profit by hedging? ›
Typically, the aim of financial hedging is to take a position on two different financial instruments that have an opposing correlation with each other. This means that if one instrument declines in value, the other is likely to increase, which can help to offset any risk from the declining position with a profit.
How does hedging work simple? ›
A hedge is a strategy that seeks to limit or offset risk in an investment or a portfolio of investments. A widely used hedging technique involves buying derivatives. Portfolio diversification is a type of hedge. Buying both cyclical and countercyclical stocks is an example.
What are the three types of hedging? ›
There are three recognised types of hedges: cash flow hedge, fair value hedge, and net investment hedge.
What is an example of a perfect hedge? ›
We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets. Example 1: Assume the price has gone down. On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.
What is a short hedge simple example? ›
A short hedge involves selling futures contracts for wheat. When the farmer sows the fields in October, the price of wheat is $600 per bushel. The farmer calls a broker with instructions to sell wheat futures that expire in June so they coincide with the harvest.
What is hedging in the English language? Hedging is using hedge words, such as "probably" and "possibly," to soften the impact of a claim. What is an example of hedging in a sentence? In the claim "it will probably rain today," probably is a hedge.
What is an example of hedging options? ›
What is an example of an option hedge? A common example of an option hedge is buying a put option on a stock you own. This gives you the right to sell the stock at a predetermined price, regardless of its market value.
What are the three hedging strategies? ›
At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate.
- Layering hedge to smooth rate impacts.
- Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)
What Is a Micro-Hedge? A micro-hedge is an investment technique used to eliminate the risk of a single asset from a larger portfolio. In most cases, a micro-hedge involves taking an offsetting position in that single asset.
How do macro hedge funds make money? ›
Global macro hedge funds are specialized investment vehicles that aim to generate returns by identifying and capitalizing on global economic trends and shifts in geopolitics. You need both strategy and adaptability to win, because the economic landscape can shift as quickly as the wind.
What are macro hedge strategies? ›
Macro-hedging strategies typically involve using derivatives to take short positions on broad market catalysts that can negatively affect the performance of a portfolio or a specific underlying asset.
What is an example of hedging a bet? ›
For example, you bet the San Francisco 49ers at +2500 to win the Super Bowl ahead of the season and they eventually make it. Instead of riding out the +2500 and hoping the 49ers win, you could hedge that bet and take the opposing team, the Kansas City Chiefs, to win on the moneyline.
What is an example of a statement using hedging? ›
What is hedging in the English language? Hedging is using hedge words, such as "probably" and "possibly," to soften the impact of a claim. What is an example of hedging in a sentence? In the claim "it will probably rain today," probably is a hedge.
