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What is Hedging?
Hedging refers to making an investment that safeguards your finances from market fluctuations. Different forms of hedging exist, but it essentially allows investors and businesses to have cover all of their bases.
Investors often hedge by taking offsetting or opposite positions to balance out their portfolios. For instance, stocks and high-grade corporate or U.S. Treasury bonds have an inverse relationship. That means when one increases in price, the other decreases.
In this article, the Zero Theft Movement will venture into the weeds and cover all you need to know about hedging. You will learn how businesses and investors can use these diverse financial instruments to achieve their goals. Also, find out how alleged abuses of hedging potentially contributed to the 2008 subprime mortgage crisis.
Long-Term Capital Management alleged trading strategies eventually failed catastrophically and led to a $3.65 billion bailout in 1998. Should the government have intervened as the lender of last resort? See what the ZT community has uncovered…
Many compare hedging to taking out an insurance policy. Take Californian homeowners, for instance. They have to worry about earthquakes due to all the fault lines in the state. Most would want to protect the value of their home (likely their most valuable asset) by taking out earthquake insurance. Nobody can stop an earthquake from happening, but you can protect your finances in case an earthquake does occur.
Hedging does involve a tradeoff. By protecting your asset from risk (e.g., price fluctuations), you also have to forego potential gains or savings. In the house example above, homeowners have to make monthly payments to have earthquake insurance. But they’re willing to pay for financial protections in the event of an earthquake. In the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible
The same applies to the investment domain. Futures contracts, for instance, where financial players buy/sell an asset (e.g., crude oil) at an agreed-upon price and date. It could decrease by the settlement date (which would benefit the buyer), but they at least secured the asset at a guaranteed price. In the investment space, hedging is both more complex and an imperfect science.
Hedging Strategies: Wall Street Investors vs Main Street Investors
The hedging strategies of Wall Street investors and Main Street (non-professional) investors differ considerably. Let’s take a look at the most common approach for each.
Purchasing derivatives such as swaps is a common way financial players hedge against underlying assets (e.g., stocks, bonds, commodities, currencies, etc.). Investors would likely want to purchase derivatives that have an inverse relationship to assets in their portfolios. This creates a balance, wherein the losses in one gets offset by the gains in the other.
To give an example, let’s say investor X buys 10 shares of ABC stock at $100 per share. Investor X hedges this investment by purchasing a put option with a strike price of $85 for a year. If ABC stocks plummet drastically within the year, investor X can sell the asset at $85 regardless of how much its price dips. He might have paid for the put option, but he managed to salvage a decent amount due to his hedging.
The optimal hedging strategy and the price of the hedging instruments will depend on the downside risk of the underlying asset. Generally speaking, the more risky the investment is, the pricier the hedge. An option which expires after a longer period and which is linked to a more volatile security will thus be more expensive as a means of hedging.
Hedging Through Diversification
Most Main Street investors likely won’t ever trade a derivative contract, however. Short-term fluctuations don’t really bother the majority of investors as they have adopted a buy-and-hold strategy. Their approach is to keep their investments in the market and let them appreciate over time. Rather than derivatives, the general investor will likely hedge through diversification.
You can own a variety of different assets that do not rise and fall collectively. For instance, one of your technology stocks could have collapsed when the dotcom bubble burst. If you had invested in other commodities (e.g., gold) and stocks from other industries, then you would not have lost everything.
The LIBOR scandal uncovered alleged manipulation of a global interest rate. Millions of contracts, including swaps, could have been affected by major banks potentially involved in the case.
Many different businesses can find use in hedging. Commodity markets, in particular, can experience a great deal of fluctuation due to unforeseen variables. A company that depends on a certain commodity might want to secure it at the current spot price. This would not only allow them to properly budget for the future but also ensure they can get a bulk order of the commodity at a price they’re (relatively) comfortable with.
A major airline, for example, needs jet fuel. Without it, the company would have no way to make a profit. The jet fuel provider might think its commodity is due for a serious dip in price, so its executives choose to offer year-long futures contracts at the current price. This strategy is known as a forward hedge. Unless the price is the same at the settlement date, one side will benefit from the deal, and the other will ‘lose.’ Nevertheless, the potential losses will at least be mitigated for the ‘loser.’
Hedge Funds & Hedging?
Hedge funds, if you think about it, do not seem to fit with the concept of hedging (i.e., risk management). But hedge funds do employ derivatives to balance their investments. They have their own privately-owned investments funds that do not come under the strict government regulations mutual funds do.
Hedge funds managers make a percentage of the returns they earn. No returns, no percentage. Many seek out hedge funds because they do not have to pay the fees involved with mutual funds. Hedge funds operate on a principle of high risk/high reward, but they aren’t trading with their personal finances. The fee structure and access to client money makes for a potentially fatal combination.
Many have alleged that hedge funds’ use of credit default swaps contributed to the collapse of the global economy in 2008. They purchased the derivatives in order to hedge potential losses from subprime mortgage-backed securities. AIG, along with other insurance companies, sold credit default obligations (CDOs), which provided protections if subprime mortgages defaulted.
As we know now, mass defaults ensued.
Photis Lysandrou, economics Professor at London Metropolitan University, wrote the following for the Financial Times: “Had it not been for hedge funds’ intermediary position between the investors seeking yield on the one hand and the banks that created the high yielding securities on the other, the supply of these securities, known as collateralised debt obligations, would never have reached the proportions that were critical in precipitating the near collapse of the whole financial system. Wealthy individuals did not have the requisite expertise to participate in the CDO market while liquidity and risk control considerations prevented institutional asset managers from having more than a limited participation. In both cases, one of the preferred solutions to the yield problem, which was becoming increasingly acute from about 2002, was to pour money into hedge funds that in turn diverted substantial amounts of this money into the subprime-backed securities. On the eve of the crisis at end-2006, hedge funds held about 47 per cent of the $3tn worth of CDOs while the banks held 25 percent and insurance companies and asset managers held the remaining 28 per cent.”
Better Markets estimated the 2008 subprime mortgage crisis caused upwards of $20 trillion in lost GDP. Millions suffered due to the crisis, while some bankers even profited from the disaster they’d allegedly caused.
Hedging allows businesses and investors to protect their assets against price fluctuations. Although hedges will often limit your ability to maximize profit, they help maintain a level of balance through temperamental periods.
Nevertheless, as seen in the case of the subprime mortgage crisis, the derivatives market can sometimes be vulnerable to abuse. In the aftermath of the economic collapse, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act, which has promoted greater transparency and accountability from hedge funds.
Hedging definitely has a place in markets, but we need proper protections in order to prevent financial disasters and foul play. The Zero Theft Movement is dedicated to finding and eliminating the rigged parts of the U.S. economy so that American businesses and citizens can flourish. Our community works to calculate the most accurate estimate for the monetary costs of corruption in the United States.
We achieve this collectively through our independent voting platform. The public investigates potential problem areas, and everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold all the bad actors accountable.
2. The Working Group shall consult, as appropriate, with representatives of the various exchanges, clearinghouses, self-regulatory bodies, and with major market participants to determine private sector solutions wherever possible.
3. The Working Group shall report to the President initially within 60 days (and periodically thereafter) on its progress and, if appropriate, its views on any recommended legislative changes.”
The Few Meetings of the Working Group
To expand on the introduction, let’s take a quick look at the events that led to the formation of the Plunge Protection Team.
While economists have debated the true causes of Black Monday, one common explanation attributes the stock market crash to two factors. Mark Carlson, a member of the Board of Governors of the Fed, points out (1) the U.S. House Committee on Ways and Means proposed new tax legislation to decrease the benefits linked to funding mergers and leveraged buyouts; and (2) the U.S. Department of Commerce’s announcement of unexpectedly high trade deficit numbers hurt the value of the U.S. dollar, increasing interest rates and decreasing stock prices.
On October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped by an unprecedented 508 points (22.6%) in a single day. The S&P 500 Index plummeted 20.4%, falling from 282.7 to 225.06. While the NASDAQ Composite decreased by just 11.3%, it exposed the failures of the NASDAQ market system.
In March 1988, President Reagan wanted to create an expert, though informal, financial advisory team to help him and regulators make economic decisions during the recovery effort. The initial intention was for the Working Group to report specifically on the crisis and recommend next steps; however the Plunge Protection Team has met throughout the years whenever the president has deemed it necessary.
In 1999, the team released a report advising Congress to request reforms to regulations of the derivatives market. It reconvened nearly a decade later to examine the 2008 subprime mortgage crisis. Most recently (as of June 2021), the Plunge Protection Team met on Christmas Eve, 2018, to discuss a bad run in financial markets.
The Mysteries of the Plunge Protection Team
While the Plunge Protection Team obviously exists, the inner workings often remain private. The minutes of its meetings, its recommendations, all of that remains privy to only the few people involved. These ‘mysteries,’ let’s say, have led observers to question whether top financial officials have the license to control the country’s (relatively) free markets.
George Stephanopoulos, former advisor to President Clinton, actually spoke on the Plunge Protection Team and its strategies in an appearance on Good Morning America on Sept 17, 2000.
“Perhaps the most important the Fed in 1989 created what is called the Plunge Protection Team, which is the Federal Reserve, big major banks, representatives of the New York Stock Exchange and the other exchanges and they have been meeting informally so far, and they have a kind of an informal agreement among major banks to come in and start to buy stock if there appears to be a problem. They have in the past acted more formally… I don’t know if you remember but in 1998, there was a crisis called the Long term Capital Crisis. It was a major currency trader and there was a global currency crisis. And they, with the guidance of the Fed, all of the banks got together when it started to collapse and propped up the currency markets. And, they have plans in place to consider that if the markets start to fall.”
On July 28, Shearson Lehman aggressively purchased stock index futures contracts when equity prices started dropping due to a loss of consumer confidence. The company’s purchases managed to mitigate the losses.
According to Buffalo News, “That day the Dow ended 51.87 points higher. Newspapers the next day said the bad news about the economy had made Wall Street believe that interest rates would decline again — a bullish move for stocks…Similar suspicious trading has occurred for months, traders say. Just last Monday, for instance, when stock prices were sliding because of the weak dollar, traders say that nearly identical orders for several hundred Standard & Poor’s 500 futures contracts were handled at the Chicago Mercantile Exchange by Shearson and Goldman Sachs.”
July 24, 2002
After the investment fervor that created the Dotcom Bubble, the collapse of NASDAQ was swift. Some companies allegedly attempted to hide their losses, leading to the Enron scandal and Worldcom scandal.
Michael Edward, from the alternative news site Rense, claims: “An event that should have sent markets spiraling downward was the Enron, et al, unprecedented corporate accounting scandals. Yet despite this, an unprecedented across-the-board markets rally began on July 24, 2002. Once again, the European Press called it a ‘PPT rally.’”
February 5, 2018
Observers cite, for example, the time DJIA dropped by 1,175 points on February 5, 2018. The loss was doubly worse than the biggest decline in the index’s history. For the two following days, stocks opened lower, but aggressive stock purchases continued to prop up markets. Some have attributed the buying to the Plunge Protection Team (New York Post and GoldSilver).
Another potential case emerged during the aforementioned meeting on Christmas Eve. Throughout the month, the DJIA had been dropping, and the S&P 500 appeared to be on the cusp of a major downturn. Nevertheless, the day after Christmas, the DJIA shot up by over 1,000 points.
December 26, 2018
That whole month, the S&P 500 had been heading towards a record decline—the motive for the team’s meeting—and the DJIA dropped 650 on the 24th alone. The Plunge Protection Team’s aforementioned teleconference on Dec. 24, 2018. But when trading resumed after Christmas, the DJIA rallied over 1,000 points. Some believe the recovery came as a result of market manipulation by the Plunge Protection Team.
Why Secret Market Intervention Could be a Problem
If the Plunge Protection Team (or any other person or entity) manipulates the market, it creates serious problems for investors.
At first blush, especially in the case of the Working Group, their potential market manipulation might seem like a positive. What investor wants to lose money on the stock market? If the allegations are true, then the team would be mitigating losses for many.
But it’s not so simple.
For one, there’s the matter of deceit. Investors operate under the assumption that the U.S. stock market is free. Any manipulation, if found, results in a criminal investigation by the Securities and Exchange Commission. Boom and bust periods happen, and all investors should be subject to the same free market forces.
Furthermore, chartered financial analyst David Amerman writes: “…[The Plunge Protection Team] is a committee that is dedicated not to investors but to the financial system. If in the interest of serving the financial system, government manipulations create excessively high prices – then by definition, investors are being cheated out of future yields. This is because for any future stream of cash flows-whether it be interest payments, dividend payments, or the future sales price-the higher the price we pay today for what the cash flow will be in the future, then the lower our future profits or returns.”
In other words, investors are not getting the proper opportunity to get in low and cash out high if the Working Group is trying to artificially maintain markets at a high price.
What can YOU do about the Plunge Protection Team?
Now, we should once again note that, due to the team’s private proceedings, most of us do not have definitive proof that the Working Group manipulates markets. Nevertheless, perhaps it might be in the public’s best interests to know just what recommendations the Plunge Protection Team makes.
What justifies keeping these discussions secret?
If the team does, in fact, manipulate markets, it would be a good case to investigate with the Zero Theft Movement. Our community works to calculate the best estimate for the monetary costs of corruption and unethical practices in the U.S. Corporate, political, and everything in between.
Stock market manipulation is one area that requires extensive investigation. If it is rigged, it can significantly reduce your savings. Citizens who want to retire may have to postpone it due to minimal returns. Not due to free market forces, but others rigging the market.
We have built a safe and independent voting platform where you and your fellow citizens collaborate to thoroughly investigate potential problem areas across the economy. Everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold the bad actors accountable. We can achieve economic justice, a financial system that allows the many good businesses (big, medium, and small) and good individuals (regardless of their socioeconomic status) to thrive.
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.