Hedging denotes protecting or insuring. In finance, it is a risk management strategy. It is a financial strategy that should be understood and used by investors because of the advantages it offers. The operations and dealings undertaken by the manufacturers, merchants, or speculators to insure themselves against the future fluctuations of prices are known as hedging. It deals with reducing or eliminating the risk of uncertainty. In the markets, it is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The aim of this strategy is to restrict the losses that may arise due to unknown fluctuations in the investment prices and to lock the profits therein. This strategy typically involves derivatives, such as options and futures contracts. It is one of the best means to reduce the unpredictable nature of a portfolio by minimizing the risk of loss. It helps to restrict losses that may arise due to unknown fluctuations in the price of the investment.
Hedging is done to minimize or offset the chance that your assets will lose value. The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures, and forward contracts. A common form of hedging is a derivative or a contract whose value is measured by an underlying asset. Say, for instance, an investor buys stocks of a company hoping that the price for such stocks will rise. However, on the contrary, the price plummets and leaves the investor with a loss.
A business can implement a hedging technique in the following areas:
- Commodities include agricultural products, energy products, metals, etc. The risk associated with these commodities is known as “Commodity Risk”.
- Securities include investments in shares, equities, indices, etc. The risk associated with these securities is known as “Equity Risk” or “Securities Risk”.
- Currencies include foreign currencies. There are various types of risks associated with it. As an example “Currency Risk (or Foreign Exchange (Currency) Exposure Risk)”, “Volatility Risk”, etc.
- Interest rates include lending and borrowing rates. The risks associated with these rates are known as “Interest Rate Risks”.
Hedging has broadly three types –
- Forward (or a Forward Contract) is a non-standardized contract to buy or sell an underlying asset between two independent parties at an agreed price and a specified date. It covers various contracts like forwarding exchange contracts for currencies, commodities, etc.
- Futures (or a Futures Contract) is a standardized contract to buy or sell an underlying asset between two independent parties at an agreed price, standardized quantity, and a specific date. It covers various contracts like currency futures contracts, etc.
- Money markets cover a variety of contracts like money market operations for currencies, money market operations for interest, covered calls on equities, etc.