What is hedging contract? A Hedge agreement is essentially an agreement between two or more parties who have decided to exchange cash flow in order to mitigate the losses and thus gain profits. This agreement can also be between hedge fund organizations and investors when a hedge fund partnership takes place between them. This kind of agreement can be created with respect to any interest rate, interest rate option, forward rate transaction, swap, commodity swap, currency swap, commodity option, commodity future, interest or commodity cap, commodity collar transaction, currency future, or option contract, etc.
When Is Hedge Agreement Needed?
A hedge agreement is needed when investors want to maximize returns and combat risks. For instance, if an investor wants to sell a product (or money) in the future without actually knowing whether its price will increase or decrease and yet, want to mitigate the losses, he/she would want to sign a hedging agreement. Investors can choose the type of partnership they want to have with other parties or hedge fund managers. In the case of hedge fund partnership, investors have to meet the required net worth, which means a hedge fund can take money mainly from accredited investors.
Purpose Of The Hedge Agreement:
- To reduce the risk
- To reduce the effects of market value changes
- For consistent cash flow
- To protect the investor’s profile and reducing losses
- To determine/ fix a sale/purchase price of a commodity
- To reduce transaction costs
Inclusions in Hedge Agreement
When an investor (or investors) decides to invest a pool of money, and a professional hedge fund manager runs that money by applying more than one type of strategy on it to provide protection against changing prices and to eliminate risk, a hedge fund partnership agreement and contract are required between these two parties.
The said agreement would mostly have names of the partners, the status of the fund, the fee that the fund or hedge fund manager would charge, the fund’s limits, fund’s strategies, etc. It is paramount to add conflict management strategies in the contract. This agreement process always requires a professional’s help or templates made by a hedge agreement expert only. The process of sample downloads from the internet should be carried out wisely and from a reliable source.
How to Draft the Hedge Agreement?
Before finalizing a hedge fund partnership, it is very important for investors to carry out thorough research and due diligence. The goal of such a partnership should be clear from the very beginning on both qualitative and quantitative parameters.
- Both parties first define the goal and nature of the partnership
- Both parties get clarity on funds
- Clarity on the clauses depending on the type of agreement
- Clarity on what both parties are going to achieve and how it is measured
- Define the time period of the partnership
- Mention hedging strategies
- Mention hedge interest rate
- Defining how profits will be divided
- Make sure the International Swaps and Derivatives Association (ISDA) standards are not breached
- Mention the details about your right to redeem shares
Benefits of Hedge Agreement
Hedge Agreement diverts only a little fund from a company, so with no asset loss, companies can run smoothly with it. In addition, companies can then better concentrate on the business front only.
Pros of Hedge Agreement:
- Both the parties can survive tough and adverse markets
- With an agreement in place both the parties will get their profits rightfully
- Both the parties get protection against changing prices, rates, inflation, etc
- With multiple strategies and few regulations, maximum returns can be gained
- Investors can anticipate their gains and losses
- Bigger investment latitude
- It can get save investors’ time
Cons of Hedge Agreement:
- Sometimes involve huge costs
- In order to minimize risk, sometimes profit can suffer
- In a good performing market, hedging gives less benefit
- Hedging requires advanced and skilled strategy
- Requires strong hedge fund operating
- Hedge fund managers may charge both expense ratio and performance fee
Types of Hedge Agreement
There can be different types of hedging strategies, such as long and short hedges, both of which are used for risk management and minimization of loss. Short hedges are mostly used when there are chances of selling the assets in the future, while long hedges are used when there are chances of buying the assets in the future. It is also suggested to use shorts hedges when the price of the contract is predicted to decrease and long hedge when the price of the contract is speculated to increase.
Major Categories –
- Interest rate swap agreement
- Interest rate protection agreement
- Foreign currency exchange agreement
- Commodity price protection agreement
- Forward rate agreement
Key Clauses in the Hedge Agreement
- Keyman clause
- Terms of investment
- Return of investment
- Regulatory disclosures
- Tax disclosure
- Risk factors and conflicts of interest
- Investment objective and strategy
[Also Read: Partnership Agreement]
What Happens in Case of Violation?
The Securities and Exchange Commission has given full power to the Financial Industry Regulatory Authority (FINRA) to protect the investors. By filling FINRA, investors can now get help against any kind breach or violation.
In case of any violation of the said clauses, both parties can also approach the SEC. SEC has it well within its rights to charge both parties. If the hedge fund manager misrepresents, hides information, or misuses the funds, an investor can also file a lawsuit. Under the Foreign Corrupt Practices Act (FCPA), the department of justice has increased scrutiny against breach of the agreement.
Sample Hedge Agreement
With multiple complexities in the procedure, it is not advisable to create an agreement without the guidance of an expert.
Pick templates only from a reliable source where they are drafted by a legal expert. It will save you money.
You can download a sample hedge Agreement here.