Hedging Introduction, Meaning & Definition, Objectives, Functions, Types, Strategies09/09/2022 0 By indiafreenotes
A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.
Hedging is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding to hedge it, in other words by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood did occur.
There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
Objectives & Functions
The basic purpose of hedging is to secure protection against fluctuation in prices. This protection is secured by shifting the risks of price changes to the professional risk-takers i.e., speculators. The traders who have to buy goods and keep them in stock for considerable periods can meet the possible ups and downs in the prices by hedging their purchases.
Similarly, a manufacturer who manufactures goods according to a carefully prepared budget can save hi-self from upsetting results of rise in the prices of raw materials by hedging in the futures market. An exporter also can save himself from possible losses due to changes in prices through hedging.
Besides insuring itself against losses from fluctuating prices a firm can receive better credit facilities from the bank if it hedges its goods.
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 Example, “Currency Risk (or Foreign Exchange (Currency) Exposure Risk),” “Volatility Risk,” etc.
Interest rates include lending and borrowing rates. The risks associated with these rates are known as “Interest Rate Risks.”
Interestingly, the weather is also one of the areas where hedging is possible.
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 (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.
It is one of the major components of financial markets; today, where short-term lending, borrowing, buying, and selling are done with a 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 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 a few strategies, which are as follows:
You can do this by buying a put option to protect a portfolio of the cash market.
Through Asset Allocation
You can do this by diversifying your portfolio with more than one type of asset. E.g., you can invest 70% in equity and the rest 30% in other more stable assets to create a balanced portfolio.
Staying in Cash
It is a ‘No Investment’ strategy. Here, the investor does not invest in any asset and thereby keeps his cash in hand.
You can do this by investing a portion of the portfolio in debt and the other in derivatives. Where the debt portion brings stability to the portfolio, the derivatives help in protecting it from the downside risk.
Advantages of Hedging
- Hedging limits the losses to a great extent.
- Hedging increases liquidity as it facilitates investors to invest in various asset classes.
- Hedging requires lower margin outlay and thereby offers a flexible price mechanism.
Limitations of Hedging:
One might think that hedging provides a complete insurance against price changes. This is not correct for hedging has its limitations due to which it may afford only an imperfect protection against losses due to fluctuating prices.
- The practice of hedging will provide full measure of protection against changes in prices if the prices in the cash market and futures market move together in perfect harmony with each other. Possibilities of a loss will arise when the prices move in opposite directions and change at different rates in the two markets. In such a case, the protective mechanism of hedging will fail.
- The contracts in the futures market relate to the contract grade or basic grade. On the cash market, a specific grade other than the contract grade may also be purchased or sold. Hedging will serve its protective purpose only if the prices of the contract grade of a futures market and the other grades of cash market move together.
- In the futures market, purchases or sales can be made only in terms of the trading units fixed by the exchange concerned. If a manufacturer’s requirements fall short of the unit, hedging will be of little use for offsetting losses against profits as between the two markets.
- Hedging may not provide enough protection to a manufacturer in case there is a rise in the cost of production, not due to a rise in the price of raw materials but because of increase in wages and other expenses. This will be so because hedging can offset losses only on account of raw materials which are traded at the commodity exchanges. It cannot obviously affect other costs entering the total cost of production.