WHAT IS HEDGING?
Simplest Explanation Ever
In the world of finance, risk is inevitable.
Whether you're a small investor managing a
personal portfolio or a multinational corporation
with vast assets, exposure to financial risk is
always present.
One of the most effective ways to protect against
these risks is through hedging.
What is Hedging?
Hedging is a risk management strategy used to
offset or reduce the probability of loss due to
price fluctuations in an asset or investment.
In simpler terms, it’s like buying insurance for
your investments to protect them against
potential losses.
Just like how you purchase insurance for your car
or home to cover potential damages, hedging
involves using financial instruments to protect
your portfolio from adverse market movements.
Why Hedge?
1. Protection Against Uncertainty: The financial
markets are often volatile, and factors like
economic changes, geopolitical events, and
natural disasters can cause asset prices to
fluctuate unexpectedly.
Hedging helps to minimize potential losses
from such unpredictable events.
2. Preserve Profit: Many investors or businesses
use hedging to lock in profits.
For example, if a stock or commodity price has
risen significantly, a hedge can protect against
a downward correction while allowing some
room for further gains.
3. Business Continuity: For companies, hedging
helps ensure that they can continue operations
even if the markets or input costs change
unexpectedly.
For example, airlines hedge fuel prices to
protect themselves against rising oil prices,
ensuring they can continue operating without
drastic fare hikes.
4. Managing Foreign Exchange Risk: For
companies that deal internationally, currency
risk can be a major concern.
Hedging foreign exchange risk allows
businesses to stabilize costs and revenues
across different currencies.
How Does Hedging Work?
Hedging typically involves the use of derivatives,
such as options, futures, and swaps, to reduce
the impact of unfavorable market movements.
These financial instruments derive their value
from an underlying asset, such as a stock,
commodity, or currency.
Here’s how the most common
hedging instruments work:
1. Futures Contracts
A futures contract is an agreement to buy or
sell an asset at a future date for a specified
price. It’s commonly used in commodities
markets (oil, gold, wheat, etc.) but also for
stocks and other assets.
Example: A farmer who grows wheat may sell
wheat futures to lock in a price for their crop
before it’s harvested, protecting against
potential price declines.
2. Options Contracts
An option gives the holder the right (but not
the obligation) to buy or sell an asset at a
specified price before a certain date.
Example: An investor holds 100 shares of
Company X. They buy a put option to sell these
shares at Rs. 100 per share. If the stock price
falls below Rs.100, the investor is protected by
being able to sell at the locked-in price of Rs.
100, minimizing losses.
There are two main types of options:
Call Option: Provides the right to buy an asset
at a specific price.
Put Option: Provides the right to sell an asset
at a specific price.
3. Swaps
Swaps are contracts where two parties agree
to exchange cash flows or other financial
assets.
Example: Interest rate swaps are common. A
company with a variable interest rate loan
might swap its payments with a company that
has a fixed-rate loan to protect itself from
rising interest rates.
4. Forward Contracts
Similar to futures contracts, forward contracts
are private agreements between two parties,
unlike futures which are traded on exchanges.
Example: A business expecting payment in a
foreign currency in the future might enter into
a forward contract to exchange the currency at
a set rate to avoid fluctuations in the currency
market.
Types of Risks Hedging
Addresses
Market Risk: Hedging shields against overall
market volatility and downturns.
Commodity Risk: Protects companies from
raw material price changes (e.g., oil, metals).
Currency Risk: Stabilizes international trade
profits by managing currency fluctuations.
Interest Rate Risk: Reduces the impact of
interest rate changes on loans and bonds
through swaps or options.
Hedging Example
Let’s say an Indian company imports machinery
from Europe and pays for it in euros.
If the euro becomes more expensive compared to
the Indian rupee, the company will have to spend
more rupees to buy euros, making the machinery
more costly.
To protect itself from this risk, the company can
use a forward contract to lock in a fixed
exchange rate.
This way, even if the euro gets stronger, the
company can still buy euros at the agreed rate,
keeping its costs stable and avoiding unexpected
price increases.
Should You Hedge Your
Portfolio?
Whether or not to hedge depends on your risk
tolerance, investment goals, and market outlook.
Hedging is more common among large
institutional investors and corporations with
specific financial risks, such as fluctuating
commodity prices or foreign exchange exposure.
For individual investors, hedging is less common,
but it can be useful in specific scenarios—such as
during periods of high volatility or when
protecting large holdings.
