What is Hedging? Is it the Key To Limit Losses?
The idea behind hedging is to offset potential gains and losses in one investment by taking an offsetting position in a related investment.
It can also be termed as an offset relationship between both the Derivatives (securities that vary in accordance with one or more underlying assets i.e. futures, swaps, options, and forward contracts) as well as the Underlying Assets (includes securities such as equities, bonds, commodities, currencies, indexes, or interest rates).
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What is Hedging?
Hedging can also be done through the use of derivatives, such as options and futures contracts, or through the use of diversification.
It is not a guaranteed way to limit losses, but it can help to reduce the potential impact of negative price movements on an investment portfolio.
One of the main benefits of hedging is that it can help to protect your assets from market volatility.
Here is a hedging example.
If you own a stock that is likely to decrease in value, they can hedge their position by purchasing a put option on that stock. A put option gives you as a holder the right, but not the obligation, to sell a stock at a specific price, known as the Strike Price.
If the stock's price falls below the strike price, the investor can exercise their option and sell the stock at the higher strike price, limiting their loss.
Apart from using this put option you also have another way to hedge, which is through the use of futures contracts. But, before that let’s understand what these future contracts are.
A futures contract is basically a legally binding agreement to buy or sell an asset at a specific price and date in the future. Investors can use futures contracts to hedge against price movements in the underlying asset.
For example, if you are concerned that the price of gold will decrease, you can finalize a futures contract on gold. If the price of gold does decrease, the investor will make a profit on their futures contract, offsetting their loss on their physical gold investment.
Hedging can also be done through diversification. Diversification is the process of spreading investments across different asset classes and markets. This can help to reduce the overall risk of an investment portfolio by spreading the risk across multiple investments.
By diversifying your portfolio, you can reduce your exposure to market volatility and limit potential losses. This must have given you a clear picture of what hedging is, why is hedging important and how it can be done using various ways. Now we will also study different curves of this hedging circle.
Firstly, let’s understand that it's worth noting that hedging is not a guaranteed way to limit losses.
Even with hedging, there is always a risk that an investment can decrease in value. Additionally, hedging can be expensive and may not always be practical for all investors.
Therefore before implementing a hedging strategy, it's important for you to carefully consider the costs and benefits, as well as the overall risk tolerance of the investor. Now, moving forward you can also take a dig into how and why do companies use hedging.
Different Companies use hedging as a risk management strategy to protect themselves against potential losses from market volatility. Since, it allows companies to lock in prices for raw materials, currency, or other assets that they use in their business operations, which can help to reduce the impact of price fluctuations on their bottom line.
For example,
You own a company that relies on a specific commodity, such as oil, for its production process and may use hedging to protect itself against potential price increases.
The company can enter into a futures contract to purchase the commodity at a specific price and date in the future, locking in a known cost for the commodity.
This can help to protect the company from potential price increases that could negatively impact its profitability.
Another example is a company that operates in multiple countries and needs to pay for goods or services in foreign currencies. They may use currency forwards or options to hedge against currency fluctuations.
This can help the company to protect against changes in the exchange rate that can affect the cost of goods or services they import or export, and therefore their profit margin.
Hedging can also help companies to manage their credit risk, by purchasing Credit Default Swaps (CDS) to protect against the risk of default of a borrower. Companies that lend money to other companies or have bonds outstanding can use CDS as a way to protect against the risk of default.
Hedging can also help companies to manage their interest rate risk, as well as protect against the impact of changes in interest rates on their profits. Companies can use interest rate swaps, options, or futures to hedge against changes in interest rates.
Conclusion
Companies employ hedging as a risk management tactic to shield themselves from potential losses carried on by market volatility.
By Hedging, companies are able to lock in prices for the supplies, money, and other assets they need to run their operations, which can assist to lessen the negative effects of price changes on their bottom line. They may control their credit risk and interest rate risk with its assistance, protecting their profits in the process.
An investment's potential losses can be reduced by using the risk management technique of hedging. You can achieve this by using diversification or derivatives like options and futures contracts.
Hedging is not a guarantee and may not always be practicable for all investors, but it can help protect an investor's assets from market volatility and limit potential losses. Before implementing a hedging strategy, it's essential to carefully weigh the benefits and drawbacks as well as the investor's overall risk tolerance.
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