Know the Importance of Hedging

Updated on : May 10, 2022 - 09:07:04 PM

08 min read.

Hedging in finance refers to protecting investments. We have covered the following in this article:

What is Hedging

Hedging in finance refers to protecting investments. A hedge is an investment status, which aims at decreasing the possible losses suffered by an associated investment. Hedging is used by those investors investing in market-linked instruments. To hedge, you technically invest in two different instruments with adverse correlation. The best example of hedging is availing of car insurance to safeguard your car against damages arising due to an accident. The hedging techniques are not only employed by individuals but also by asset management companies (AMCs) to mitigate various risks and to avoid the potential negative impacts. Hedging does not prevent the investments from suffering losses, but it just reduces the extent of negative impact. Hedging is employed in the following areas:

Securities Market: This area includes investments made in shares, equities, indices, and so on. The risk involved in investing in the securities market is known as equity or securities risk.
Commodities Market: This area includes metals, energy products, farming products, and so on. The risk entailed in investing in the commodities market is referred to as the commodity risk.
Interest Rate: This area includes borrowing and lending rates. The risk associated with the interest rates is termed as the interest rate risk.
Weather: This might seem interesting, but hedging is possible in this area as well.
Currencies: This area comprises foreign currencies and has various associated risks such as volatility and currency risk.

Types of Hedging Strategies

Hedging strategies are broadly classified as follows:

Forward Contract: It is a contract between two parties for buying or selling assets on a specified date, at a particular price. This covers contracts such as forwarding exchange contracts for commodities and currencies.
Futures Contract: This is a standard contract between two parties for buying or selling assets at an agreed price and quantity on a specified date. This covers various contracts such as a currency futures contract.
Money Markets: These are the markets where short-term buying, selling, lending, and borrowing happen with maturities of less than a year. This includes various contracts such as covered calls on equities, money market operations for interest, and currencies.

How do Investors Hedge

The AMCs generally employ the following hedging strategies to mitigate losses:

Asset Allocations: This is done by diversifying an investor’s portfolio with various classes of assets. For instance, you can invest 40% in the equities market and the rest in stable asset classes. This balances your investments.
Structure: This is done by investing a certain portion of the portfolio in debt instruments and the rest in derivatives. Investing in debt provides stability to the portfolio while investing in derivatives protects you from various risks.
Through Options: This strategy includes options of calls and puts of assets. This facilitates you to secure your portfolio directly.

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.

Conclusion

Hedging provides a means for traders and investors to mitigate market risk and volatility. It minimises the risk of loss. Market risk and volatility are an integral part of the market, and the main motive of investors is to make profits. However, you are not in a position to control or manipulate markets in order to safeguard your investments. Hedging might not prevent losses, but it can considerably reduce the effect of negative impacts.

Hedge Funds & How They Differ From Mutual Funds

Types of Risks Associated With Mutual Funds