Hedging in finance is a practice that revolves around safeguarding your investments. It doesn’t matter what your investment type is, every investor should practice hedging for portfolio protection.
At first glance, hedging may seem like a gardening term but it is a beneficial practice that every investor should understand and follow. In the financial world, hedging is a way to ensure portfolio protection and is just as important as expanding and diversifying your portfolio. It is not an esoteric requirement for advanced investors. This financial strategy is useful for everyone, especially those who have just stepped into the investing world.
Are you intrigued by the idea of hedge investment? In this blog, we will discuss hedging in finance, its types, and the various pros and cons of hedge trading.
What is Hedging?
In layman’s terms, hedging in finance simply means protecting your investments from potential losses. You can think of it as a form of insurance for your investments. When you decide to hedge, you are protecting yourself from an unexpected negative impact on your investments. However, this doesn’t mean you won’t suffer any losses during a loss, it means that when a negative event does happen, and you are hedged, the impact of the loss is greatly reduced.
One of the best examples of hedging is getting car insurance to protect your vehicle from accidental damages. In order to hedge, you have to invest in two different hedging instruments with adverse correlations(car and car insurance).
Hedge investments are not only used by individuals. In fact, many corporations and portfolio managers also take advantage of hedging to mitigate various risks and avoid potential negative impacts on their investments.
However, in the financial world, hedging is not as simple as paying an insurance premium every month. Hedging against risks includes strategically planning your investments to offset negative impacts. In simple terms, investors hedge one investment by investing in another instrument.
Hedging is employed in the following areas:
- Securities Market: This sector involves investments made in stocks, indices, equities, and more. The risk in the securities market is known as securities risk or equity.
- Commodities Market: This sector includes tangible items like metals, agricultural products, energy products, and more. The risk in the commodities market is known as commodity risk.
- Interest Rate: This sector includes lending and borrowing rates. The risk associated with this area is known as interest rate risk.
- Weather: While this might seem insane, it is possible to hedge in this sector as well.
- Currencies: This sector involves foreign currencies and has many associated risks like volatility and currency risk.
How Do Hedge Investments Work?
Hedging in finance involves the use of financial instruments called derivatives. Options and Futures are two of the most popular derivatives. With investing in derivatives, investors can easily trade strategies where a loss in one instrument is counterbalanced by a gain in a derivative.
Example #1
Suppose you own shares of Volg’s Vodka Company(VVC). Although you are sure about the long-term growth of the company, you are worried about some minor short-term losses. To safeguard yourself from these losses, you can buy a ‘put option’ on the company, which gives you the right to sell VVC shares at a specific price(strike price) up to a specific period.
This strategy is known as a married put and uses options as derivatives to offset the losses. If the share price goes down below the strike price, you can offset the losses by gains in the ‘put’ option.
Example #2
Another example of hedging instruments involves a company that depends on a particular commodity for production. Suppose Volg’s Vodka Company(VVC) is worried about the fluctuations in the price of potatoes(a common ingredient to make vodka). The company would suffer losses if the price of potatoes skyrockets and it will impact their profits.
To protect itself from this uncertainty, VCC can enter into a futures contract or a forward contract.
A futures contract is a type of hedging instrument that allows the company to buy potatoes at a set price at a specified date in the future. With this, VCC can bypass the volatility and continue production without any troubles.
If the price of potatoes goes above the price specified by the future contract, VCC will save money by paying the price specified in the future contract. However, if the price of potatoes goes below the specified price, the company(VCC) is still obligated to pay the price specified in the futures contract. And would have to pay more due to hedging.
As there are a wide variety of futures and options contracts, investors can hedge their investments against nearly anything including stocks, commodities, interest rates, currencies, and even weather.
Types of Hedging
Physical Hedging
Physical hedging generally involves a company that needs to make future payments in international currencies. They might purchase a futures contract for foreign currencies to lock in a favourable exchange rate. This way they can meet their payment obligations without worrying about any upcoming currency fluctuations.
Financial Hedging
In forex, financial hedging refers to using hedging instruments like derivatives to counterbalance potential risks. This includes investment strategies like options and swaps for managing currency risk.
- Options offer investors the right to purchase a call option or a put option on a currency at a specified price, offering risk mitigation in the market.
- Swaps involve the exchange of cash flows, interest payments, or currencies between two parties to manage currency rate fluctuations. This strategy is commonly used by businesses and investors.
Forward Contract
A forward contract is an agreement to exchange a particular currency for another at a specified exchange rate at a future date. It is used to protect against adverse currency rate fluctuations.
Short Straddle
Short straddle in forex involves shorting a call or put option on the same currency pair with the same price and expiration date. This strategy is used to gain from low volatility in the market.
How Do Investors Use Hedge in Investment?
Investors generally use the following hedging strategies to protect against losses.
Asset Allocation: This refers to diversifying an investor’s portfolio by investing in different asset classes. For example- you can invest 50% in equities and the rest in stable asset classes. This balances out your investments and offers protection in case one of your investments plummets.
Structure: This refers to dividing your portfolio between debt instruments and derivatives. Investing in debt offers stability while derivatives safeguard from potential risks.
Through Options: This strategy includes options of call and put on assets. This allows you to protect your portfolio directly.
Advantages and Risks of Hedging
Advantages of Hedging
Protection of Portfolio: Hedging in finance can be used to protect a portfolio from potential risks, especially for investors with extra exposure to international markets that tend to fluctuate.
Flexibility: Hedging can be highly flexible. Investors can create tailored strategies for specific trading objectives and risk tolerance, allowing traders to manage their exposure accordingly.
Avoid Margin Calls: Hedging also helps in avoiding margin calls by offsetting losses with profits. This prevents the requirement of securing additional capital.
Stress Reduction: Hedging can be a great stress reduction tool as it makes it easier for investors to use their strategies while protecting against extreme market fluctuations.
Risks of Hedging
Costs: One of the basic risks of hedging includes increased transactional costs associated with premiums for options or fees for hedging instruments like futures contracts.
Reduces Gain Potential: Hedging is known to limit gains as it involves sacrificing upside potential to protect against downside losses. With hedge investments, investors may miss out on favourable price fluctuations.
Complex in Nature: While hedging is beneficial for both advanced and beginner investors, its strategies are quite complex and require a deep understanding of financial instruments. Beginner traders and businesses may find it hard to implement the best strategy according to their situation.
Over-hedging: Over-hedging is also a lingering possibility. It can lead to unnecessary costs and missed gaining opportunities. It is crucial to maintain the right balance between risk management and revenue potential, which can be quite tricky.
No Assurance: Contrary to popular belief, hedging doesn’t eliminate all risk or assure gains. The market is volatile and can change unexpectedly, meaning your hedging instruments will not always perform like you want.
Counterparty Risk: Another common risk of hedging is counterparty risk. When using derivatives, there is a counterparty risk. If the counterparty defaults, you can incur heavy losses.
Best Hedging Strategies for Investors
Pairs Trading
Pairs trading is a hedging strategy that revolves around identifying and capitalizing on price discrepancies between two pairs of currency that are correlated. The strategy includes taking opposite positions in these pairs simultaneously to gain from their fluctuations. Most investors use currency pairs that tend to move together over time due to factors like economic fundamentals or geopolitical events. By going long on one currency pair and short on another, investors aim to gain from the fluctuation of the two pair’s prices.
Currency Swaps
Currency swaps are financial agreements to exchange one currency for another at a predetermined rate. This hedging strategy is generally used by financial institutions, governments, and multinational companies.
In this strategy, two parties agree to exchange one currency for another currency. The exchange rate of the currencies is fixed at the beginning of the contract to mitigate the risk associated with adverse exchange rate fluctuations. By locking in the exchange rates, the participants in a currency swap ensure stability in cash flow and also protect themselves from unexpected losses resulting from extreme currency fluctuations.
Delta Hedging(Arbitrage)
Delta hedging is another common hedging strategy that is also known as Arbitrage. It is generally used in the options market and involves adjusting positions in the spot market to counterbalance the sensitivity(delta) of an options contract.
The delta of an options contract measures the rate at which the contract’s price fluctuates. In order to hedge delta risk, investors take offsetting positions in the spot markets.
For example- if an investor holds a call option on a currency and the delta indicates a potential loss if the currency goes down, they might short the equivalent of that currency in the spot market. This strategy neutralizes the directional risk of the option.
Risk Reversal
Risk reversal is a hedging strategy that includes combining a long call option position with a short put option(or vice versa) on the same pair of currencies. This strategy is especially useful to hedge against directional risks while retaining the flexibility to gain from both bear and bull markets.
Investors use risk reversals when predicting moderate volatility in a currency pair but want protection against extreme price fluctuations. They purchase a call option and gain potential benefits in case of upward price movements, while simultaneously shorting a put option creates income and limits losses in case of downward price movements. Risk reversal is a versatile strategy and offers investors a balanced approach to managing the uncertainties of the market.
Final Words
Every investment comes with some sort of risk. Some investors even believe that risk is an integral element of investing. Whether you are an advanced or beginner investor, it is crucial to have a basic understanding of hedging in finance, hedging instruments, and how they work. It is important to understand how investors and companies use basic hedging strategies to protect themselves from risks.
Learning about hedging will help you get a better grasp of the market and help you advance as an investor. Make sure to also understand how to properly use complex derivatives to mitigate risks and protect your investments from losses.
Frequently Asked Questions(FAQs)
Q. What are the basic principles of hedging?
Ans. Hedging generally means protecting your investments. It can be done by using derivatives like options and futures contracts. By establishing a price, the trader protects against subsequent declines in price, but also generally eliminates any potential gain if subsequent prices rise. Through hedging with futures, producers can greatly reduce the financial impact of changing prices which may result in unfavourable results.
Q. What is a commercial hedger?
Ans. A commercial hedge is a company that uses the derivatives market to hedge its market exposure to either the items it produces or the inputs needed for those items. For example- a vodka company requires potatoes to produce vodka. It may buy potato futures to hedge against the rising prices of potatoes.
Q. What is De-hedging?
Ans. De-hedging means to close out of an existing hedge position. This can be done if the hedge is no longer required or if the hedge is expensive.
Read More: Hedge Funds: A Comprehensive Guide to Strategies, Risks, and Success
