Hedging is an insurance-like investment that protects you from risks of any potential losses to your finances. The purpose is to eliminate or reduce the risk by offsetting the potential loss. However, if one reduces the risk through hedging, it leads to the minimization of the reward associated with the trade as well.
Normally, a hedge consists of taking an offsetting position in a related security, which offset the risk of any adverse price movements. It can be done through various financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes. such as forward contracts, futures, options, etc.
Table of contents
- Hedging is a risk management strategy involving offsetting positions to minimize potential losses from adverse price movements in an asset or portfolio.
- Hedging can be done using various financial instruments such as options, futures, swaps, or forward contracts.
- The purpose of hedging is to protect against downside risk, stabilize cash flows, and preserve the value of assets or investments.
- Hedging is commonly used by individuals, companies, and institutional investors to manage risks associated with currency fluctuations, interest rate changes, commodity price movements, and more.
Hedging is similar to insurance as we take an insurance cover to protect ourselves from one or the other loss. For example, if we have an asset and we would like to protect it from floods. As humans, it is not in our hands to directly protect it from flood, but in this case, we can take an insurance cover so that if there is any damage to our property on account of floods, we get compensated for the same.
Here, reducing the risk might reduce the reward also. In the case of insurance, we pay a premium, and we might not even get any benefit from the premium if there is no flood during the tenure of the policy. Hedging, similarly, isn’t free either. We have to pay a cost for it, which reduces the overall rewards which we get. Hedging can be done for items that have a fixed value or for items that have a variable value.
Hedging can be done for items that have a fixed value or for items that have a variable value.
Let us try and understand these in more detail:
#1 – Hedging for Fixed Value items
A fixed-value item is one that has a fixed value in your books of accounts and requires an outflow of a fixed amount of cash in the future.
Some examples of Fixed Value Items are:
- A fixed-interest loan is taken by the company with semi-annual fixed-interest payments.
- Fixed coupon non-convertible debentures issued by the company with annual interest payments
As it is obvious, in this type of hedge, the amount/rate is fixed much in advance, and this may / may not be in sync with the current market rates when the payment actually takes place. This is the reason why companies enter into hedging even for fixed-value items.
#2 – Hedging for Variable Value items
As opposed to fixed-value items, variable-value items have fluctuating cash flow at the time of payment.
Examples of Variable Value Items are:
- Variable interest loans (these loans are generally based on some benchmark rates + a fixed percentage above it)
- Foreign exchange transactions
- Variable non-convertible debentures
Hedging Explained in Video
Traders/Investors assess the incoming cash from each of the portfolios before they determine the hedging technique to use. Some of the techniques that they take into consideration include:
- Futures Hedge: This is the futures contract, which traders involve in to hedge risks when they find the commodity or currency market is to witness downfall. In this case, they book a deal at a predetermined price for a future date, which remains unaffected by market fluctuations.
- Forward Hedge: It is evident while hedging in FOREX. The foreign exchange risks associated with exporting and importing can effectively be dealt with using this technique. Here, the traders involve in a forward contract with banks to make sure their portfolio is not affected by the adverse rate changes.
- Money Market Hedge: As the name suggests, the money market hedge technique helps lock the value of a foreign currency transaction with respect to the domestic currency value.
Hedging can only be effective if the right strategy is applied. Some of the strategies that help reduce market risks are as follows:
Building a strong portfolio is one of the most effective ways of hedging. To achieve this, investors/traders must consider diversification. Having diversified portfolios with a few groups of assets with lower risk levels allows them to take trades that guarantee profits. Taking one trade to have a stronger backup to cover up for the losses could be the best hedging approach.
This is the hedging alternative, allowing investors to buy a put option for an individual stock with significant liquidity. They do it to ensure the downside move turns ineffective. Though it is a useful tool to reduce risks arising in the market, it is effective only when investors have an individual stock to deal with. It becomes an insignificant approach for those having a diverse portfolio.
Keeping a watch on the volatility index or VIX indicator helps investors understand the price fluctuations happening in the market. The indicators rise as and when volatility increases. If the VIX level is below 20, the volatility is considered low. On the contrary, if the level exceeds 30, the market is said to be volatile.
Let us consider the following examples to understand hedging in finance:
Example 1 – Conceptual
Most of the areas under the scope of business and finance can be covered under hedging.
Let us take an example of a manufacturing organization that supplies its products in the local market and is also involved in exports. Let’s assume that its export sales form 75% of its revenue. The company will have an inflow of foreign currency as a primary source of revenue. The value of this foreign currency may keep fluctuating and could lead to gains/losses.
In order to restrict this potential loss, the company might consider this through either of the following activities:
- Build its own factory in a foreign country so that goods manufactured there can easily be sold without any foreign currency fluctuations. This is one way to avoid currency risk.
- They can also enter into a contract with a bank to sell their foreign currency at a fixed rate by paying the fees/premiums for the same.
- Enter into a contract with its major customers to pay them in their home currency.
So a company can hedge a given risk in more than one way. The organization can decide which of the available options is the best (given the availability of its resources and the constraints).
Example 2 – Fixed Value items
Let us say the organization has issued non-convertible debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer. at an 8% p.a. coupon rate, and coupons are paid annually. In this case, the organization feels that the interest rate prevailing in the market at the time of the next coupon payment (due in a month) is going to be lower than 8% p.a.
So the organization decides to enter into a hedging contract with a bank where it will receive 8% p.a. interest on the underlying amount of the non-convertible debentures from the bank and, in return, pay LIBOR + 0.25% p.a. interest on the underlying amount.
Following will be cash flows which the organization will incur if the interest rate decreases (Case A) or the rate decreases (Case B):
|Payments without hedging||Case A||Case B|
|Actual coupon payment||$ 8,00,000||$ 8,00,000|
|Payments with hedging|
|LIBOR RateLIBOR RateLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions. at the time of payment||7.25%||8.25%|
|The interest rate at which the organization will have to pay the bank||7.50%||8.50%|
|(LIBOR + 0.25%)||$ 8,00,000||$ 8,00,000|
|Actual coupon payment|
|Add: Organization will pay the bank||$ 7,50,000||$ 8,50,000|
|Less: Organization will receive from the bank||$ 8,00,000||$ 8,00,000|
|Net Payment||$ 7,50,000||$ 8,50,000|
|Benefit / (Opportunity Loss) on account of hedging||$ 50,000||$ (50,000)|
Example 3 – Variable Value items
Now let us say that the organization has taken a loan of $ 1,00,00,000, which has a semi-annual interest payment at LIBOR + 0.50% p.a. The current LIBOR rate is 7% p.a. but the organization believes that the LIBOR rate is going to increase in the near future. So the organization enters into a contract with the bank where it will receive LIBOR + 0. 50% p.a. and pay a fixed rate of 7% p.a. to the bank.
Following will be cash-flows which the organization will incur in the given two scenarios:
|Payments without hedging||Case A||Case B|
|The total interest rate applicable||8.00%||6.75%|
|Interest Payment||$ 8,00,000||$ 6,75,000|
|Payments with hedging||Case A||Case B|
|Interest Rate payable to the bank||7.00%||7.00%|
|Actual coupon payment||$ 8,00,000||$ 6,75,000|
|Add: Organization will pay the bank||$ 7,00,000||$ 7,00,000|
|Less: Organization will receive from the bank||$ 8,00,000||$ 7,00,000|
|Net Payment||$ 7,00,000||$ 7,00,000|
|Benefit / (Loss) on account of hedging||$ 100,000||($ 25,000)|
From the above, the organization has restricted its outgoing payment to $ 7,00,000 irrespective of the market rate. This is the opposite of the Fixed Value hedge, where they let go of a fixed outgoing pay and converted it to flexible payments.
Advantages & Disadvantages
Hedging offers a number of benefits to traders using different strategies. However, it does have flaws. Let us have a look at the pros and cons of the process:
|Short-term strategy to reduce risks associated with long-term investments||Involves charges|
|Helps lock profits beforehand in case an investment seems to incur losses||Allows adjustment portfolio based on market volatility|
|Offers protection against price changes, rate changes, etc.||Effective for short-term traders|
|Allows adjust portfolio based on market volatility||Requires significant trading skills|
Hedging Vs Speculation Vs Arbitrage
Hedging, speculation, and arbitrage are terms have similar objectives, but they differ in the way they are used and the markets they are used in for maximum risk mitigation and profit making. Let us have a look at the differences below:
|Meaning||It is the process to help traders offset risks using existing investments.||It is the process that helps traders take trade by speculating the fluctuations in prices at a later stage.||It is the process that helps traders profit from the difference in the price of an asset in two different markets.|
|Risk involved||Avoids risks||High risk||Limited risk|
|Helps to||Manage currency risks||Profit from exchange rate movements||Buy/sell in one market and sell/buy the same security in a different market with profitable price|
Frequently Asked Questions (FAQs)
Hedging is essential because it allows individuals and businesses to mitigate the potential impact of adverse price movements on their portfolios or operations. By hedging, investors can reduce the volatility of their investments and protect against potential losses.
Standard hedging techniques include:
a Using options to protect against downside risk.
b Entering into futures contracts to hedge commodity price fluctuations.
c Utilizing currency swaps to hedge foreign exchange exposure.
d Employing interest rate swaps to manage interest rate risk.
Hedging can help mitigate risks, but it cannot eliminate them. There may be situations where the hedging strategy incurs costs or does not perfectly offset the risk. Additionally, unexpected events or extreme market conditions can impact the effectiveness of hedging techniques.
Hedging strategies can involve costs, such as transaction fees, premiums, or margin requirements. Additionally, there is a risk that the hedging instrument may not perfectly correlate with the underlying asset, resulting in imperfect hedging. It is essential to consider the costs and limitations of hedging before implementing a strategy.
This has been a guide to Hedging and its meaning. Here we explain its strategies, examples, types, vs speculation, advantages, disadvantages & vs arbitrage. You may learn more about derivatives from the following articles –