Hedging

Hedging Meaning

Hedging, in finance, is a risk management strategy. It deals with reducing or eliminating the risk of uncertainty. The aim of this strategy is to restrict the losses that may arise due to unknown fluctuations in the investment prices and to lock the profits therein. It works on the principle of offsetting i.e. taking an opposite and equal position in two different markets. In simple terms, it is hedging one investment by investing in some other investment.

Generally, when people plan to hedge, they try to ensure themselves against a negative event. This does not prevent the event from occurring, but it surely reduces its impact. Not only individual investors but portfolio managers and large corporations also use this hedging technique to minimize the exposure to various types of risks and decrease the negative impact thereon.

Hedging Example

Let us understand Hedging by a simple example.

When you buy a life insurance policy, you support and secure your family’s future in case of your death or any serious injury in some accident.

Similarly, when you secure your ‘A’ investment’s loss by offsetting it with ‘B’ investment’s profit, it is known as ‘Hedging’.   Hedging

Areas of Hedging and their Risks

A business can implement a hedging technique in the following areas:

Commodities

Commodities include agricultural products, energy products, metals, etc. The risk associated with these commodities is known as “Commodity Risk”.

Securities

Securities include investments in shares, equities, indices, etc. The risk associated with these securities is known as “Equity Risk” or “Securities Risk”.

Currencies

Currencies include foreign currencies. There are various types of risks associated with it. As an example “Currency Risk (or Foreign Exchange (Currency) Exposure Risk)”, “Volatility Risk”, etc.

Interest Rates

Interest rates include lending and borrowing rates. The risks associated with these rates are known as “Interest Rate Risks”.

Weather

Interestingly, the weather is also one of the areas where hedging is possible.

Hedging Types

Depending on these areas, it has broadly three types

Forward

Forward (or a Forward Contract) is a non-standardized contract to buy or sell an underlying asset between two independent parties at an agreed price and a specified date. It covers various contracts like forwarding exchange contracts for currencies, commodities, etc.

Futures

Futures (or a Futures Contract) is a standardized contract to buy or sell an underlying asset between two independent parties at an agreed price, standardized quantity, and a specific date. It covers various contracts like currency futures contracts, etc.

Money Markets

It is one of the major components of financial markets today, where short-term lending, borrowing, buying, and selling are done with the maturity of one year or less. Money markets cover a variety of contracts like money market operations for currencies, money market operations for interest, covered calls on equities, etc.

Hedging Strategies

A hedging strategy generally refers to the risk reduction technique of an investment. There can be no standard strategy to hedge various financial instruments like forwarding contracts, options, swaps or stocks because these strategies require constant modification as per the type of market and investment, which requires hedging. To face such situations, a business can implement few strategies which are as follows:

Through Asset Allocation

You can do this by diversifying your portfolio with more than one type of asset. For e.g. you can invest 70% in equity and the rest 30% in other more stable assets, to create a balanced portfolio.

Through Structures

You can do this by investing a portion of the portfolio in debt and the other in derivatives. Where debt portion brings stability to the portfolio, the derivatives help in protecting it from the downside risk.

Through Options

You can do this by buying a put option to protect a portfolio of the cash market.

Staying in Cash

It is a ‘No Investment’ strategy. Here, the investor does not make an investment in any asset and thereby keeps his cash in hand.

Conclusion

Hedging is one of the best means to reduce the unpredictable nature of a portfolio by minimizing the risk of loss. This, in turn, helps the market to run in an orderly and efficient manner.1,2

Share Knowledge if you liked
Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

Related Posts

6 thoughts on “Hedging”

  1. I WANT TO EXPLANATION OF HEDGING LOSS OR GAIN BETWEEN BANK

    EXAMPLE:
    I BOOKED A CONTRACT FOR INR TO USD @ 74.50 FOR 1.00LAKH USD ON 01/07/2021 TO ONE YEAR VALIDITY
    I CANCELLED THE CONTRACT ON 31/07/2021 SOME INTERNAL REASON THAT TIME OF SPOT RATE USD1 = INR75.50 IS THIS CONTRACT PROFIT OR LOSS?

    Reply
    • Prima facie there is a gain in the contract (75.50-74.50) Re 1 per quantity. However, this depends upon the quantum of premium you have paid for booking the contract. If the premium is < 1 Lakh (1*100000) then you are at a profit or vice versa.

      Reply

Leave a Comment