Hedging is a risk management strategy. It deals with reducing the risk of uncertainty related to the adverse price fluctuations in an asset. 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 insure 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.
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’.
Areas of Hedging and their Risks
A business can implement hedging technique in the following areas:
Commodities include agricultural products, energy products, metals, etc. The risk associated with these commodities is known as “Commodity Risk”.
Securities include investments in shares, equities, indices, etc. The risk associated with these securities is known as “Equity Risk” or “Securities Risk”.
Currencies include foreign currencies. There are various types of risks associated with it. For e.g. “Currency Risk (or Foreign Exchange (Currency) Exposure Risk)”, “Volatility Risk”, etc.
Interest rates include the lending and borrowing rates. The risks associated with these rates are known as “Interest Rate Risks”.
Interestingly, weather is also one of the areas where hedging is possible.
Not only for reducing risk, hedging is also useful as a means to earn profits by trading in various commodities, securities or currencies. Depending on these areas, broadly there are three types of hedging:
Forward (or a Forward Contract) is a non-standardized contract to buy or sell an asset between two independent parties at an agreed price and a specified date. It covers various contracts like Forward exchange contracts for currencies, commodities, etc.
Futures (or a Futures Contract) is a standardized contract to buy or sell an asset between two independent parties at an agreed price, standardized quantity, and a specific date. It cover various contracts like currency futures contracts, etc.
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.
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 forward 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:
Hedging 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.
Hedging 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 in the portfolio, the derivatives help in protecting it from the downside risk.
Hedging through Options
You can do this by buying a call option and selling a put option and vice-versa. This helps directly in protecting the portfolio, especially the equity portfolio.
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.
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.