Hedging: A Behavioral Approach to Risk Management

An illustrated guide to hedging: Weighing the pros, such as loss minimization and stability, against the cons, including potential missed gains and strategic complexity.

Hedging and Prospect Theory

Hedging is central to modern risk management, but its motivations are often misunderstood. While many see it as a tool for balancing financial outcomes, its foundation lies in behavioural economics—specifically Prospect Theory. This theory, developed by Daniel Kahneman and Amos Tversky, explains why individuals prioritize avoiding losses over achieving equivalent gains. Hedging means protecting against adverse outcomes rather than maximizing profits.

This blog examines how hedging aligns with Prospect Theory’s loss aversion and whether it’s solely about risk mitigation—or can also create opportunities.

Hedging and Prospect Theory: A Behavioral Perspective

Prospect Theory highlights two key principles:

1. Loss Aversion: People dislike losses more than they enjoy equivalent gains. For instance, losing $100 feels worse than gaining $100 feels good.

2. Reference Points: Decisions are made relative to a reference point, usually a baseline expectation or the status quo.

These principles explain why decision-makers favour hedging—it’s more about minimizing losses than maximizing gains.

Real-World Examples of Hedging "Against" Risks

1. Currency Hedging

An exporting company might hedge against adverse currency fluctuations by using forward contracts to lock in exchange rates.

• Historical volatility in exchange rates (e.g., GBP/USD) shows how unhedged exporters could lose up to 15% of revenue annually.

• By hedging, businesses ensure stability and avoid significant financial loss, even if exchange rates eventually move in their favour.

2. Commodity Hedging

Airlines frequently use futures contracts to hedge against rising fuel prices.

• Fuel costs are the most unpredictable part of their operational budget. Airlines mitigate this uncertainty by locking in prices using derivatives.

• For example, Ryanair's hedging strategy saved over €1.4 billion in FY23. In comparison, Delta Air Lines experienced losses of $4 billion over eight years due to poor hedging but refined its approach by acquiring an oil refinery to better control costs.

In both cases, loss aversion drives these decisions, as the focus remains on avoiding catastrophic financial disruptions.

Can You Hedge "For" Opportunities?

While hedging typically mitigates downside risk, some strategies blur the line between hedging and speculation, positioning for positive outcomes.

1. Weather Derivatives

Farmers might use weather derivatives to benefit from favourable conditions. For instance, payouts during stormy seasons could offset opportunity costs, indirectly supporting revenue during good harvests.

2. Dual-Hedging

Industries like Steel use dual hedging to protect against price drops while allowing gains during surges.

• Such strategies stabilize supply costs while capturing unexpected market opportunities.

• According to a Deloitte survey, 78% of CFOs use hedging to minimize downside risk, underscoring the dominance of loss aversion over speculation.

Hedging in personal life

It is about reducing risks and uncertainties by diversifying options, creating backups, or making balanced decisions. It's similar to financial hedging but applies to daily life situations. This is how we hedge our risks:

Financial and Lifestyle Hedging

• Savings Accounts and Investments: Keeping money in high-risk stocks and low-risk bonds.

• Emergency Funds ('Rainy days" ): Maintaining liquid cash reserves for unexpected expenses.

• Insurance Policies: Health, life, and property insurance to cover unforeseen losses.

• Housing Strategy: Renting instead of buying in uncertain job markets.

• Transportation: Owning a car and a bicycle or relying on public transit when fuel prices surge.

Career Hedging

• Side gigs: Starting a side hustle or freelancing while working full-time.

• Upskilling: Learning new skills to switch careers if needed.

• Networking: Building relationships across industries to keep opportunities open.

Health Hedging

• Healthy lifestyle: Investing in preventive health care to avoid long-term illnesses.

• Medical Checkups: Regular screenings to catch problems early.

• Alternative Therapies: Exploring multiple approaches to health and wellness.

Relationships and Social Life

• Friendship Tiers or Groups: Maintaining connections with different groups (work, family, hobby) to avoid over-reliance on one circle.

• Emotional intelligence: Developing strategies to prevent breakdowns in relationships and conflict escalation.

Hedging promotes preparedness, flexibility, and reduced dependence on a single path. Yet, most hedging strategies aim to mitigate risks rather than capture opportunities.

Hedging "For" vs. "Against" Risks

Ultimately, hedging aligns with the psychology of risk-averse decision-makers. It safeguards the reference point—a portfolio value, budget target, or profit margin.

While mitigating risks in corporate life is pretty natural, our lifelong strategies should also seek opportunities other than playing ostrich. It takes guts, though...