Profits from investment always come with risk, whether it can be market risk, currency risk or interest rate risk. An investor is always concerned about how to eliminate or reduce such risk. One of such techniques to reduce risk is “Hedging”.
In today’s blog post, we will give you an overview of hedging, along with its features, types and advantages.
Meaning of Hedging
Hedging is a risk management tool used by investors to protect their portfolio against losses due to adverse price movement of a particular underlying asset. It is typically known as insurance for your investment portfolio. It can be implemented using various financial instruments called derivatives, etc.
Features of Hedging
The following are the key features of hedging :
- Risk Management: It is generally used to minimise the risk of a portfolio due to fluctuation in the price of the underlying asset.
- Derivatives: Hedging can be implemented using derivative tools such as futures, options, etc.
- Volatile Market: The effectiveness of hedging depends on the market volatility and the type of instrument used in it.
- Cost: Usage of hedging comes with costs such as premiums paid for an option, etc.
Types of Hedges
The various types of hedges are as follows:
1. Forward Hedge
Under a forward hedge, two parties enter into the contract to buy or sell a particular asset at a future date for a fixed price. These contracts are customizable based on the needs of the parties.
2. Future Hedge
Future hedging contracts are standard contracts that are traded on an exchange. It allows an investor to buy and sell a particular asset at a set price in the future.
3. Money Market Hedge
Money market hedges are used by the investor to protect their bond portfolio against currency risk.
4. Option Hedge
Through buying an option, the investor gets the right but not the obligation to buy and sell an asset at a specific price before the expiry of the contract. This helps protect against unfavorable price movements.
Read Also: What is Future Trading and How Does It Work?
Hedging Strategies
The key hedging strategies are as follows:
- Asset Allocation: It is done by diversifying an investor’s capital across different types of assets. For example, you may invest 30% of your money into stocks and the rest into fixed assets to help balance your portfolio. However, this allocation depends on the investor’s risk profile.
- Structure Investment: Under this type of strategy, a portfolio of investors is kept in debt, while the remaining portion is kept in derivatives. It ensures that the debt fetches a stable return, whereas the derivative investment helps in the protection of the portfolio against risk.
Examples of Hedging
The various examples of hedging are as follows:
- Stock Hedging: For example, an investor is holding Reliance Industries stock in the cash market and is worried about the decline in its price. Then he can hedge his position by buying a put option, which gives them the right to sell at a fixed price in case of a fall in the price of the underlying stock.
- Commodity Hedging: These are used by the individual who trades in commodities, etc. For example, a farmer has grown crops, but he is worried about the price drop in future. In this case, a farmer can hedge its risk by selling the futures contract for its crop at the current price.
- Portfolio Hedging: In this type of hedging, the investor hedges their entire portfolio. Let’s say Mr A has a holding of Pharma-related companies, and he wishes to hedge his portfolio against any downside risk. Now he can sell the future contract of the IT index and mitigate its risk.
Read Also: Types of Futures and Futures Traders
Advantages of Hedging
The key advantages of hedging are as follows:
- Reduce Risk: The key benefit of hedging is that it protects the portfolio against the adverse impact of price movements.
- Increases Confidence: Once the investor comes to know that the portfolio is protected against loss, it increases their confidence.
- Diversification: Portfolio hedging spreads the risk across various asset classes, helping to reduce the risk of the portfolio.
Risk of Hedging
There are several risks involved while using hedging. A few of such risks are mentioned below:
- Cost: Hedging involves various costs, such as transaction costs, premiums, etc. This can reduce the effectiveness of the strategy.
- Market Risk: The market risk persists; however, hedging tries to eliminate such risk. But it cannot be eliminated.
- Liquidity: There might be certain cases where the liquidity in a particular derivative contract is limited. Hence, it might be difficult for an investor to exit their position.
Read Also: Different Types of Derivatives in India
Conclusion
In conclusion, hedging is a clever strategy used by traders and investors to guard their portfolios from possible deviations. It can undoubtedly assist in lowering down the risk metric to a more manageable level, even though it isn’t totally eliminated. However, it is crucial to understand how it operates before attempting any hedging strategy and if at all possible, consult a financial advisor. Hedging carries its own set of risks which need to be considered further.
Frequently Asked Questions (FAQs)
What are the types of hedging?
The most common types of hedging are forward hedging, futures hedging, options hedging, etc.
Does hedging eliminate 100% risk?
No, hedging does not eliminate 100% risk; however, it can reduce it to a certain level and can also reduce profit potential.
Why is hedging used by investors?
Hedging is generally used by investors to reduce the risk related to unexpected price movement, unfavourable losses in the portfolio.
Does hedging require only derivatives?
No, hedging does not always require derivatives; hedging can also be done through diversification of a portfolio across different industries, etc.
Does hedging involve any cost?
Yes, hedging of a portfolio involves some additional cost, such as option premiums paid, transaction costs, etc.
