HEDGING | Top B-school in Bangalore for MBA

Posted by Dr. Samiya Mubeen On 30/03/2022 10:15:22

Introduction 

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event's impact on their finances. This doesn't prevent all negative events from happening. However, if a negative event does happen and you're properly hedged, the impact of the event is reduced.

In practice, hedging occurs almost everywhere. For example, if you buy a homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Top B-school in Bangalore for MBA

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade-in another. PGDM course in Bangalore

Technically, to hedge requires you to make offsetting trades in securities with negative correlations. Of course, you still have to pay for this type of insurance in one form or another.

For instance, if you are long shares of XYZ corporation, you can buy a put option to protect your investment from large downside moves. However, to purchase an option you have to pay its premium.

A reduction in risk, therefore, always means a reduction in potential profits. So, hedging, for the most part, is a technique that is meant to reduce a potential loss (and not maximize potential gain). If the investment you are hedging against makes money, you have also usually reduced your potential profit. However, if the investment loses money, and your hedge was successful, you will have reduced your loss.

Basic Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Suppose you own shares of Cory's Tequila Corporation (ticker: CTC). Although you believe in the company for the long run, you are worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option on the company, which gives you the right to sell CTC at a specific price (also called the strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

Another classic hedging example involves a company that depends on a certain commodity. Suppose that Cory's Tequila Corporation is worried about the volatility in the price of agave (the plant used to make tequila). The company would be in deep trouble if the price of agave were to skyrocket because this would severely impact their profits.

To protect against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract). A futures contract is a type of hedging instrument that allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating price of agave.

If the agave skyrockets above the price specified by the futures contract, this hedging strategy will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract. And, therefore, they would have been better off not hedging against this risk.

Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including stocks, commodities, interest rates, or currencies. Best B-school in Bangalore

Hedging Means for Investors 

The majority of investors will never trade a derivative contract. In fact, most buy-and-hold investors ignore short-term fluctuations altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?

Even if you never hedge for your own portfolio, you should understand how it works. Many big companies and investment funds will hedge in some form. For example, oil companies might hedge against the price of oil. An international mutual fund might hedge against fluctuations in foreign exchange rates. Having a basic understanding of hedging can help you comprehend and analyze these investments.

Advantages of Hedging

  • Futures and options are very good short-term risk-minimizing strategies for long-term traders and investors.
  • Hedging tools can also be used for locking the profit.
  • Hedging enables traders to survive hard market periods.
  • Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
  • Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
  • Hedging using options provides the trader an opportunity to practice complex options trading strategies to maximize his return.

Disadvantages of Hedging

  • Hedging involves costs that can eat up the profit.
  • Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
  • For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
  • If the market is performing well or moving sideways, then hedging offers little benefit.
  • Trading of options or futures often demands higher account requirements like more capital or balance.
  • Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

 

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