Finance

Hedging in Financial Markets

Hedging in Financial Markets

Hedging normally happens everywhere. For example, when you’re buying homeowner’s insurance, you are hedging or protecting yourself against a variety of unforeseen disasters like fires, robbery, etc. To reduce the risk while investing, all individual investors, portfolio managers, and corporations use hedging techniques. However, hedging in financial markets is not as straightforward as paying an insurance company an annual fee.

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What is Hedging?

The simplest way to understand this concept is to think of it as a form of insurance. People who decide to hedge, are basically insuring themselves at the odds of an unfortunate event and its impact on their money. Hedging doesn’t or cannot protect one from all the negative circumstances. However, if such an unseen event does occur and you’re accurately hedged, by a dependable hedge fund, the aftermath of the event is diminished. Thus, Hedging for investment risk is defined as strategically using financial instruments or other strategies to minimize the risk of any adversity. You usually reduced your potential profit too if the investment you wish to hedge against earns profit.  However, if they lose money, and your hedge was victorious, your loss will be minimized. 

Hedging strategies and the financial instruments used :

Hedging techniques are normally used for financial instruments known as derivatives. The most common derivatives used all around the world options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative. Suppose you own shares of Bill’s clothing Cooperation. You trust the company in the long run, but some short-term losses are worrisome in the clothing industry. To protect yourself, you can purchase a put option on the company, that enables you with the right to sell shares of Bill’s at a certain price (also called the strike price). This strategy is also called a married put. 

Example:

An example could be a company that depends on a certain commodity. Suppose that Bill’s Clothing Corporation is worried about the volatility in the price of cotton(they specialize in cotton clothes). The company would be in deep trouble if the price of cotton were to skyrocket because this would severely impact their incomes

Therefore, to protect against the uncertainty of cotton prices, Bill’s can register into a futures contract (or its cousin, the forward contract). It’s a type of hedging instrument that enables the company to purchase the cotton at a set price for a set date in the future. Now, Bill can easily estimate their budget without thinking about the cotton prices. 

If the cotton price skyrockets above the price mentioned by the futures contract, this hedging strategy is successful as Bill saves money by buying cotton at the lesser price. But, if the price goes down, Bill’s will still have to pay the price in the contract. 

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Reasons for Hedging :

     1.To Reduce Long-Term Risk:  It can reduce a business’s overall risk. There will always be a  certain amount of risk that comes with hedging, however, it has the greater potential to turn out successful. The most important thing is to use the proper strategy when hedging derivates, to increase one’s chances of a great return.

     2.To Avail More Opportunities: Diversification is extremely important for any business to create more profit. Hedging in a variety of fields can significantly increase the possibility of making more profits.

     3. Protection Against Market Fluctuations: It’s an effective way to protect the company against unexpected rises in certain relevant commodities. If you don’t want your business to suffer because of the varied changes in the market, diverse hedging is key.

Key Takeaways: 

  • Hedging is an amazing risk management strategy built to reduce losses in investments by choosing an opposite position in an asset.
  • The risk is always there, but a good hedging fund supporting your business chances is mostly positive. 
  • Hedging strategies are mostly with derivatives, like options and futures contracts.

 

Author: Nishtha Bahal

About the Author: I’m a go-getter at life to collect small bits of knowledge from every part of the world. I see the world as a playground, full of swings and slides of different colors just waiting to be enjoyed upon. I believe that opportunities can be created rather than waited for, and I thus dedicate every step of mine in the direction of constructing never-ending possibilities for myself.

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