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Every smart investor needs to think about hedging, which is a type of risk management strategy. As a concept, it’s relatively simple: it involves making an additional purchase or trade to offset potential losses on your primary investment, sort of like insurance.
Where it gets tricky is in its implementation, which can involve different types of strategies. In this post, we’ll provide several examples to show you how it works.
Big companies often make smart hedges to head off otherwise crippling losses. Take a famous example: In the 2000s, oil prices surged, hitting the airline industry hard.
But Southwest Airlines saved billions of dollars because of an intelligent hedge: before the oil price rise, the airline had bought long-term contracts for oil at an agreed upon price.
Even as oil hit $140 per barrel, it was paying just $51, helping it maintain profitability even as competitors struggled. This is a classic example of what’s known as commodity hedging, an investment that protects against a surge in the price of commodities like oil, wheat or gold.
Whether or not various methods of hedging are halal is a subject of debate. Especially since hedging can involve different mechanisms, some which may run against principles of Islamic finance.
On the one hand, hedging often involves purchasing derivatives — things like options, futures and swaps.
Many Islamic scholars argue that these violate Islamic finance principles because they involve uncertainty (gharar),and can entail not actually owning the underlying asset. Some argue they amount to a type of gambling.
On the other hand, things like futures contracts (as with the above Southwest Airlines example) can help reduce volatility and uncertainty and are often tied to real-world, tangible assets, so some scholars consider certain variations of them permissible.
Read more: Why Many Common Securities Trading Strategies Are Considered Haram
First, let’s consider some common examples of traditional hedging deployed by companies and traders in order to explore the concept in general terms, and then we will discuss a few types that are specifically tailored to be halal.
International companies have to deal with currency risk, or the possibility that profits could shrink because the currency they’re earning in suddenly weakens against the currency they convert to when repatriating profits.
To hedge against that, they might buy a futures contract that locks in a certain exchange rate, similar to how Southwest Airlines locked in a future oil price.
Interest rate fluctuations can make the cost of a company’s debt increase, another major risk that will eat into profits. To hedge, companies that rely on debt financing can use interest swaps to lock in a fixed rate on their debt, protecting against a hike in interest rates.
Stocks are inherently risky as they can fall in price at any time. A common hedging strategy is to purchase what are known as put options.
These protect against a decline in the stock price by allowing you to sell your shares at a predetermined floor price (known as a “strike price”).
This means that even if the stock suddenly hits a sharp decline, you guarantee yourself the right to sell it no lower than a certain price level, protecting against much larger losses.
Absolutely not. Hedging can simply mean making investments that are likely to move in price inversely to your primary assets.
For example, gold tends to do well in down markets as it's seen as a safe haven. That makes it a type of hedge for your overall portfolio. Similarly, real estate can be a hedge against inflation, since real estate prices typically move up with overall prices in the economy.
For those who want to be certain that their hedging strategy is halal, the ever-growing world of Islamic finance has developed an assortment of tools for hedging on investments that avoid speculation, interest-based transactions and the uncertainty that comes with traditional derivative-style investments.
Here’s a few examples:
1- Salam contracts - similar to forward contracts, these allow for the sale of a commodity for deferred delivery at a predetermined price with clearly defined terms. That means you can hedge against the possibility that a key input or raw material for your business will sharply rise in price.
2- Istisna contracts - these are much like salam contracts, except they apply to manufacturing of goods or construction rather than the purchase of raw commodities. An example of this would be a real estate company that wants to lock in the price of a future project to hedge against the possibility that materials like steel and cement might rise and make it costlier to execute.
3- Murabaha contracts - These are cost-plus financing contracts that avoid interest payments by having one party sell an asset to another at a marked up price that can be paid back in installments. They can hedge against rising prices in the future by locking in a price now.
Read more: What is the difference between Musawmah and Murabaha?
4- Sukuk - These are Islamic bonds that provide returns based on underlying assets rather than interest payments.
They can be part of a hedging strategy since they are not subject to interest rate risks and provide predictable returns (as opposed to conventional bonds which will experience price drops during times of rising interest rates). They can hedge against market volatility since they are tied to stable assets.
Read more: Comparative Analysis: Sukuk Funding Vs Traditional Financing
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
