Hedging: Basic Understanding, Types, Strategies and Risks

What is the hedge: Hedging is an investment done to diminish the risk involved during adverse price movements in security or assets. Typically, it refers to holding an offsetting position in a concerned asset or security to overcome the gains or losses incurred by a companion investment.

It can be made out of different types of financial instruments which includes forward contracts, options, stocks, swaps, insurance, exchange-traded funds, gambles, derivative products, over-the-counter and future contracts.

Public futures market established in the 19 century allows standardized, efficient and transparent Hedging in agricultural commodity rates. They have expanded and now include futures contracts for hedging the prices of foreign currency, interest rate variations, precious metals and energy.

Etymology

Hedging is an act of establishing an offset position in one market and balancing against the risk raised by predicting a position in an opposing market or investment. Word hedge has taken from an old English word hecg, means any fence artificial or living.

Types of Hedging

There are various forms in which we can use Hedging, including currency exchange trading or forex trading. Type of hedge has significantly increased with time.

The increase in sophistication of investors led to the rise in the use of mathematical tools to calculate various values known as models hence increasing types of hedge. Some examples of this are as follows:

  • Money Market Operations for interest
  • Covered Calls on equities
  • Currency future contracts
  • Short Straddles on equities or indexes
  • Money Market Operations for currencies
  • Bets on elections or sporting events.
  • Forward Exchange Contract for interest
  • For interest Future contracts
  • For currencies Forward exchange contract

Hedging Strategies

Back-to-back Hedging

The act or practice of immediately closing the open position referred to as back-to-back Hedging. An example is purchasing a particular commodity in the market on the spot. The commodity market is the place where this technique is often applied. When the price of a product is directly calculated from noticeable forward rates at the time of customer sign-up

This strategy minimizes risk to some level but still has certain drawbacks such as liquidity risk and large volume.

Tracker Hedge

It is the technique which works on a pre-purchase approach. As soon as the maturity date comes, the open position is closed.

Delta-Hedging

It helps in mitigating the financial risk in option by using Hedging against the price fluctuation on the underlying asset. It is also known as Delta because it is the first derivative of option value in consideration to underlying asset price.

Risk Reversal

Risk reversal refers to simultaneously purchasing and selling an asset by using the call option and put option, respectively. It leaves a long simulating effect on commodity or stock position.

Hedging and the Everyday Investor

Most investors do not use Hedging in their day to day financial activities. They are the one who tries to make a long term strategy and ignores the continual fluctuation of the given security. The best example of this is the people who save for retirement and are not interested in trading contract derivatives. In such a case, short-term variation is not critical because the asset will grow with the overall financial market.

For investors who believe in buying and holding stocks, there is no reason for them to learn Hedging. Still, they should have a basic understanding of it because they are attached to the companies or firms that practice it regularly. Moreover, for tracking and comprehensively analysing the action of these larger companies, it is essential.

The Risk Involved in Hedging

Hedging is a strategy used to reduce risk, but at the same time, one should be aware of its downsides.

The first drawback is, it is imperfect practice and no guarantee of future success. Second, it does not ensure to mitigate the losses.

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