What is Hedging and How Does It Work?

Hedging is the act of an investor making some appropriate positions in either a security-specific or other markets to minimize the risk of undesirable movement in the value of security already owned. One can think of it as buying insurance on investments, quite like one would buy insurance to protect against potential risks to one’s car or home, and this would help safeguard one’s financial assets from market moves.

Understanding Hedging

In its simplest form, Hedging involves taking an opposite position in an offsetting-related asset so that potential adverse price movements of an investment can be mitigated. For example, if you are the long owner of a stock, scared of an impending downtick in the market, you would likely hedge by buying some options on the very same stock. If the stock falls, gains from the put will serve to alleviate losses on your shares.

Why is Hedging Important?

The market is always unpredictable, and investing activities always involve risky business. That might suddenly swing your value in investments, be it for economic policies, geopolitical events, or, for that matter, unusual corporate news. Hedging provides the ability to control those risks by reducing the potential for losses and preserving some exposure to the market. Hedging, therefore, comes with extra importance to retail investors and businesses that are exposed to various types of risks, from currency swings to changes in interest rates and commodity prices.

Common Hedging Strategies

1. Futures Contracts: These are standardized contracts to sell or buy an asset at a specified time at an agreed-upon rate. Very often, futures hedge against price shifts in resources like oil, gold, and agricultural products to cut just a few. For instance, a farmer may take up futures contracts to lock in the selling price of the crop well ahead of harvesting, therefore ensuring safe outcomes if the prices fall.
2. Options Contracts: Options are the right granted but not an obligation to buy or sell an asset at a predetermined price before the fulfilment of the contract. For instance, buying a put option against a stock is a right to sell that stock at a given price; thus, potential losses are limited.
3. Currency Hedging: Companies, or other types of investors, accepting exposure related to foreign-felt currency movements can minimise risk by taking place in currency hedging related to that position. This helps in mitigating losses that may be accrued due to an adverse movement of the exchange rate. For example, an Indian exporter can hedge against a depreciating rupee by booking forward dollars by selling at a fixed rate.
4. Interest Rate Hedging: This kind of risk deal manages the fluctuating interest rate risk. Companies holding variable-rate loans might enter into interest rate swaps, which allow them to swap these for fixed-rate payments to avoid uncertainty.
5. Portfolio Hedging: In this kind of hedge, investors hedge the whole of their portfolio either by shorting their market indices or by buying inverse ETFs. This kind of Hedging helps one during that time frame when the markets are falling and most of the value in most of the stocks would decline.

Pros and Cons of Hedging

Pros:

• Risk Reduction: This is the biggest advantage of Hedging; it lessens risk and safeguards the investor from probable losses.
• Stability: Hedging can stabilize a business’s finances because it locks the costs or revenues provided by that particular industry, which is of great importance in very volatile industries.
• Diversification: Hedging can provide diversification since it aims at safeguarding investments from adverse movements in the market.

Cons:

• Cost: Hedging is not free—it incurs costs in the form of premiums for options or fees for futures contracts. All these costs should lead to a decrease in returns.
• Complexity: Some hedging techniques are complex, entailing the requirement for a great and intensive understanding of financial markets.
• Limited Gains: Although a hedge guards against losses, it also puts a ceiling on potential gains. For example, if you were to hedge against a decline in a specific stock and the price of that stock were to increase, your hedge may limit how much of a gain you realize.

Real-world examples of Hedging

Commodity Hedging

Suppose a jewellery manufacturer in India bases its operations on gold. Therefore, when the price of gold rises, the cost of production goes up, and its profit percentages go down. In today’s scenario, the manufacturer has a second option. He can go with gold futures contracts that would provide a hedge against the potential rise in gold prices. The gains from the contracts would wipe out the increased costs if the gold prices rose.

Currency Hedging

It is experienced more for Indian IT companies because revenues are earned in foreign currency. For instance, an Indian IT firm gains most of its revenues in US dollars. When the rupee appreciates against the dollar, the lesser units of currency in rupees are required to purchase 1 unit of dollar currency causing revenues to erode. To hedge this exposure, such a company will look to acquire a fixed rate dollar in a forward sale, and hence, rupee revenue becomes stable.

Hedging in the Indian Market

While it is the flavour of Hedging for retail investors in the developed markets, in India, it is yet to gain popularity partly because of the associated complexity and cost. Institutional investors and corporates, however, do often hedge against currency risks, commodity price risks and interest rate risks.

Conclusion 

Hedging is a powerful tool for managing the risk of financial markets. It reduces the potential gain, but only with the primary purpose of protecting against huge losses and providing for much more stabilized and predictable returns. For Indian investors, learning and undertaking hedging strategies could be a very important step in negotiating the unpredictable undercurrents of the global and local markets. 

The idea behind Hedging is that it can indeed reduce the risks, but for this, strategy and a deep understanding of financial instruments are required. As with all investment strategies, the cost/benefit analysis should always be considered with reference to your financial goals whenever you implement a hedging strategy.

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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.