Academic journal article Journal of International Business Research

130/30 Investment Strategies: Hedging in a Classroom Setting

Academic journal article Journal of International Business Research

130/30 Investment Strategies: Hedging in a Classroom Setting

Article excerpt

INTRODUCTION

The typical investor buys and sells individual investment positions with the expectation of buying into a position "low" and then later selling the position "high." This approach to investing is called buying and selling "long." The investor purchases a stock or bond anticipating something will cause the investment to increase in value. Sales at a company could be increasing faster than expected. New and better company managers may have been brought on board. Interest rates in the economy could go up--or down. Many reasons can account for an investment to change in value.

The investor who thinks "long" is looking to get a positive return on each individual investment. With experience, such investors recognize that not every investment chosen will go up in value. Such investors go "long" with the expectation that enough right decisions will ensure overall positive returns. To deal with the risk of something unexpected happening, "long" investors will diversify their investment portfolio by buying several kinds of investments, such as stocks and bonds, and by buying investments from a variety of business types such as consumer goods, consumer durables, and consumer finance.

The hedge fund investor approaches investing differently. Instead of buying at one time and selling at another, the hedge fund investor will carry out two related investment actions at the same time. Here the expectation is that the investor will be buying one investment and selling another related investment in such a way the two investments counterbalance each other (Markese, 2006; Reichenstein, 2004). This becomes a different way of dealing with risk. The "long" investor diversifies a portfolio to deal with risk. The expectation is that the same negative outcome will not affect a whole diversified collection of stocks and bonds. The hedge fund investor deals with risk by acquiring two related investments at the same time. This is done in such a way that if the first investment goes down in value, the second investment will go up in value. The opposite also intended. If the second investment goes down in value, the first investment will go up in value. On the surface at least, it seems that some form of hedging must be the perfect investment strategy.

INVESTMENT TOOLS USED IN HEDGES

Many different investment tools can be used to help build a hedge even though the use of any particular tool does not automatically create a hedge. The tools are described here to prepare the reader to understand some basic hedge situations.

The first tool that can help build a hedge is the use of "margin." "Long" investors put up their own money to buy stocks and bonds and create their own portfolio. An investor with $100,000 that is available for investment and using her/his own money can only purchase $100,000 of stocks and bonds. However to have more to invest, an investor can borrow additional money from a broker. The current rule is that ordinary investors, you and I, can borrow up to 50% of the total cost of an investment. That means that an investor with $100,000 can purchase up to $200,000 of stocks and bonds. When the investments purchased on margin go up in value, the investor's return is significantly increased. At the same time when the investments purchased on margin go down in value, not only will the use of borrowed funds significantly decrease the investor's return, the investor will be subject to a margin call as the amount of the loan from the broker is adjusted to the now reduced value of the investment (Gannon, 2005). In the "With Margin" column of Table 1, the loss of 25% of investment value means the investor has to come up with an additional $25,000 because the broker can only loan 50% of the reduced value of the investment.

The use of margin not only has a significant impact on investment return; it also increases the cost of investing as the broker will charge interest on the loan. …

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