Hedge Clause

"They can't block the view!" One kind of hedge clause...one you might find in a deal you struck when your neighbors hired an ambitious new gardener.

In finance, it relates to a clause that indemnifies the authors of a financial document against liability if an error gets spotted later.

You've been put in charge of writing the press release for your company's annual earnings report. You get the internal documents, which show a profit of $10 million in the quarter. You write a release trumpeting the profit. Minutes after you send the doc out to journalists, you get an email from the finance department: there was a typo in the internal documentation. The company actually posted a loss of $10 million for the quarter.

Uh-oh. You call your lawyer to see if you're personally liable for the misinformation you just disseminated to millions of actual and potential investors. Luckily, there was a hedge clause, so the answer is "no." That clause provides you with indemnity against the error. Thanks to this clause...looks like Christmas came early this year.

Related or Semi-related Video

Finance: What is a hedge fund?41 Views

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finance a la shmoop. how does a hedge fund work? so you've probably heard a lot

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about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]

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your money. that hedge funds are only investing vehicles for the wealthy and

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how mathy their employees are. but the actual workings of a hedge fund are a

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lot like driving down a road in wartime. there are hills and there are valleys

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your car will Traverse wanting it to speed up and slow down but as long as

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you continue to drive 37 miles an hour the enemy radar can't detect you so you

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drive theoretically, safely down the road. alright so how does this translate to

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financial investments in a hedge fund well essentially every investment made

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on an entity going up in value is usually offset by making a bet on a

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different entity going down in value. that's called hedging got it? the economy

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is coming out of the doldrums and you believe the entire stock market is gonna

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recover but you believe the worst companies which have been down some 90% [chart showing decline]

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in this bad bear market environment will actually do better over the next period

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of time than high quality companies like Coca Cola which didn't decline as much.

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that is yes Coca Cola stock will improve and you think it has Headroom to run

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upwards some 30% in the next year and a half but you believe crap burgers

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dot-com which went from $100 a share at its peak to only $2 today could

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quadruple to 8 bucks in value over that same 18 months. like you get a much

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better percentage return on crap burgers than you do on coke. so as a hedge fund

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manager one quote easy unquote trade that you'll make is too short coca-cola

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betting essentially that it will go down, and then putting the same amount of

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money to being long crap burger com betting essentially that it'll go up. in

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essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]

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than coca-cola will go up but if the overall market goes down

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well you'll be hedged in that you're short Coca Cola position will cushion

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the blow of crap burgers further demise and it's likely you're looking at crap

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burgers balance sheet and thinking well they have $2 a share in cash and no debt

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how much lower can they go .got it? hedge funds use stock options

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aggressively to manage risk in their portfolios the promise hedge funds make

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to investors is that their performance will be up and/or good whether the

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market goes up down or stay sideways. so another common hedge trade involves the

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use of put options on the market to protect the long trades the fund is

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making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]

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and believes that they will be up significantly over the next two to three

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quarters earnings reports. but it's also nervous about nukes in North Korea in

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order to protect against a bomb going off and the whole market going down and

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ruining its investment performance, and yes there are bigger things to worry

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about then but that doesn't matter to hedge funds not their job. the hedge fund

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goes long the three stocks it likes but it buys put options on the market

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betting with those options that the market itself will go down. it's

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essentially playing both sides of the fiddle so that hopefully it wins in any

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set of circumstances. and yeah it's a lot more complicated than that in practice

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we're just given the idea here. in the case of a put option the market might be

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trading at ten thousand and a put option might have a strike price of nine

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thousand such that if the market declines below nine thousand the put [strike price illustrated]

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option goes quote in the money unquote and pays the investor handsomely for

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making the bet that the market would go from ten thousand and well somewhere

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below nine thousand. if that happened the three long stock bets that the hedge

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fund made would go down but their decline would be hopefully more than

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offset by the gains from the put options the hedge fund bought that were

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portfolio life insurance in the case the market puked. and if that happens well

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all you can really do is offer the market a breath mint and a moist

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towelette and then be sure to collect your fee. [person representing stock market offered towelette]

Find other enlightening terms in Shmoop Finance Genius Bar(f)