Hedging

A hedge offsets an exposure rather than removing it. Two forms are in common use. A direct hedge takes the opposite side of the same instrument in the same size, so the two results mirror each other. A cross hedge uses a different but correlated instrument, in which case only the correlated part of the movement is offset and the remainder, sometimes called basis risk, stays live. What is left after either is the net position.

How the two positions are recorded depends on the accounting system the account runs. Under netting, an opposite order reduces or closes the existing position and one net position per instrument exists. Under hedging accounting, both stay open as separate line items, each with its own entry cost and its own overnight financing. The margin held against a hedged pair is set by the firm and differs between firms and between instruments, so it is a term to read rather than to assume.

The most common misreading is that a direct hedge is a free pause. It is not free: the offsetting position crosses the spread again, adds a second commission, and leaves two financing lines running, and the two financing rates are set independently, so a pair with no exposure at all can still accrue a nightly cost. The positions also remain subject to the close-out arithmetic on the account. Practitioners disagree on whether a same-instrument hedge achieves anything a close does not, one view holding that it preserves a record and a tax or reporting position, the other that it is an expensive way to hold nothing.