Thursday, August 25, 2005

To Hedge or Not to Hedge ...

... is not the question. Everyone hedges their risks to some extent based on their belief in what the market for any product will be and their belief in how likely their expectations are to be wrong. Whether they buy or sell derivatives or whether they make long term changes to their habits, consumers attempt to mitigate their risk based on their perception of future price changes.

Every investment faces risk. In spite of popular belief, locking money securely away (as opposed to investing it in the stock market or interest-bearing investment) also carries risk. The value of your money will go down if there is inflation and if there is an opportunity cost of not investing in a higher yielding investment. There are risks associated with spending and not spending your money as well. You may spend your money on a good that generally appreciates in value (land, paintings, etc.) or on a good that generally depreciates in value (cars, computers, etc.). On the other hand, you might choose to save your money now, but you will lose out on any benefits you may have reaped from owning the good in the present. Let me illustrate with an example. Suppose you have a room but no bed. You decide that saving your money is better than spending your money so instead of purchasing a bed for $500 now, you decide you will buy one in a year. For now, you'll sleep on the floor and lock $500 away to buy a bed in a year. For that year, you have to live with the discomfort of sleeping on the floor, so you are not reaping the benefits of owning a bed for that period of time. If the price of beds drops to $400, you may consider that a reasonable tradeoff. But if the price of beds rises to $600, not only have you sacrificed the comfort of sleeping in your own bed for a year, you have sacrificed the $100 gain in value had you purchased the bed a year ago and kept it locked away instead of the $500.

CNN reported on a company that is allowing small investors to hedge their risks in gasoline prices, mortgages and inflation on a mini futures exchange market.

HedgeStreet operates a kind of futures exchange in which customers can take a position on where they believe gas prices, mortgage rates and inflation, and other indicators are headed by buying contracts called "hedgelets."

As its name suggests, San Mateo, Calif.-based HedgeStreet aims to provide tools for investors to hedge, or reduce risk, in their portfolios.

For instance, if your daily commute requires you to fill up at the pump often and you want to reduce your exposure to rising gas prices, you can take a "yes" or "no" position on whether gas will exceed, say $2.32 a gallon by the end of the month. If you make the right call, you take home a fixed payout of $10 for each hedgelet you own; if you make the wrong call, you lose your original investment.

Some experts say such contracts can be dangerous for those who don't understand the principles of investing.

But according to Mark Longo, a trader and former member of the Chicago Board Options Exchange, these products offer everyday investors insurance against market risks, such as a housing bubble or interest rate hike

Whether people purchase derivatives or not, they are always taking some position in the market, evidenced through their purchasing (or saving) habits. It is quite ironic that investing in derivatives is characterized as risky and likened to gambling, when derivatives are a tool for reducing risk that consumers already take. The above story comes after this one, on how consumers are dealing with high gasoline prices. Read some of the stories, "'I moved to a new apartment so that I could walk to work, and shorten my wife's drive. We've gotten our daily mileage down from 80 to 20, but we live in a more dangerous and noisy neighborhood.' -- Doug M." Doug is obviously making a bet that the price of his commute will remain sufficiently high as to warrant his move to a more dangerous neighborhood, and taking that risk -- a much higher risk than purchasing a more liquid investment such as derivatives -- in hopes of mitigating another risk: the possibility of continually rising gas prices.

Every decision indicates a particular preference and expectation of the market. Before you think of any financial decision as 'risk-free,' remember to consider the possibility that your market expectations could be wrong.

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