Hedging

Table of Contents

What is Hedging?
Hedges and Hedge Funds
How do Hedging Strategies Work?
What Is a Commercial Hedger?
What Is De-Hedging?
When should you hedge currency?
Types of Hedging Strategies
How do Investors Hedge
Areas of Hedging
Examples of Hedging Strategies
Frequently Asked Questions

What is Hedging?

Hedging is one of the most useful practices that every investor should be aware of. It is a type of risk management strategy that is used to avoid losses in the market by assuming an opposite position in a related asset. Investors thus save or insure themselves against a negative impact on their finances through this. It also requires one to pay money, known as a premium, for the protection it provides.

Hedges and Hedge Funds

Hedge funds are alternative investments that are very actively managed by making use of risky and contemporary strategies to ensure a high profit. They charge much higher fees and also require high minimum deposits. Investors who like to take risks or are looking for an oversized profit usually go for these type of strategies. These strategies are usually opted for when an investor wants to beat the average returns on investment.

How do Hedging Strategies Work?

One of the most common forms of hedging is a contract or a derivative whose value is measured by an underlying asset. Incidents that can cause loss to investors are avoided through these strategies as they work in a way which balance the loss. One can also choose an option hedging strategy which allows the person in the contract to make a profit from the stock’s decline in price. This profit avoids at least a part of his loss from buying the stock.

What Is a Commercial Hedger?

A commercial hedger is a company or a producer which produces different kinds of units. They offer products that can be used as derivatives to hedge their market exposure and enable the desired profit or input from the product itself or the inputs they use to make the product. An example of this can be a cosmetic company that hedges against pigments and oil pricing.

What Is De-Hedging?

De-hedging means to remove oneself from the position of hedging, thus coming out of one’s insurance or protection against losses. This is usually opted for when the protection or hedge is no longer needed or the price of hedging has surpassed the budget of the investor. Many investors also choose to de-hedge if they think that they are ready to take on some risk.

When should you hedge currency?

Currency risk is something that cannot be determined simply by a few calculations. However, it can be mitigated by using hedging strategies. The right time to hedge currency is when you see that there are constant fluctuations or there are about to be these fluctuations. This will help you to influence the fluctuations in the currency more and will help you to reduce the effect of it on your investment.

Types of Hedging Strategies

Hedging

Diversification: This type of hedging strategy includes investors investing in more than one sector so that if one sector is affected, his other investments are not negatively impacted.

Arbitrage: It is a slow but steady process. It involves buying a stock and selling it immediately for a higher price.

Average Down: This strategy involves buying more units of the stock whose cost or selling price has already declined. This ensures that one is investing small but earning big when prices rise.

Staying in Cash: In this strategy, the investor keeps a part of his money in cash to hedge against possible losses in his investment.

How do Investors Hedge

An investor makes a careful study of the patterns of different sectors and makes use of different hedging strategies including staying in cash, arbitrage and diversification. Investors hedge one investment by making a trade in another. This helps the investor by ensuring that he is protected against negative impacts in all his investments. An investor can also hedge by buying a stock at a lower price and selling it at a higher price

Areas of Hedging

There are many areas in which one can use hedging strategy like in commodities including oil, sugar, gas and dairy. Another popular area of hedging is security most commonly found in the form of bonds or stocks. Other areas that can easily be hedged include weather, interest rates and currencies.

Examples of Hedging Strategies

One should always use more than one hedging strategy to ensure the best for himself and avoid losses. For example, when an investor opts for a diversification strategy and invests in buying stocks from a restaurant, a hospital, a hotel, and a golf course. If the restaurant and the hotel face losses, the other areas would not be affected.

Frequently Asked Questions

What is the major disadvantage of hedging?

While hedging helps an investor by reducing his potential risk, it still cuts into the potential reward of the investor. It is also not easy to choose the right hedging strategy. As hedging is not free, it has to be bought. Making use of such services also does not work when the main position yields profits as planned. This makes hedging an unnecessary expenditure.

What is the difference between hedged and unhedged funds?

While a hedged fund is protected and reduces the risk of an investor significantly, an unhedged fund is fully exposed to market and exposure risk. There is no form of protection available in these funds and investors can face losses.

How does a company hedge against currency risks?

Many companies have exposure to foreign markets and hedge currency risks by making use of strategies like signing swap forward contracts. This contract enables the investor to lock in the price they pay for the currency. This ensures that the company is safe from future or near fluctuations.

What are common hedging strategies?

Most investors opt for diversification in hedging strategies as it helps them offset losses in their investments. They also make use of the staying in cash strategy to help them be prepared in case any of their investments go downhill. Some investors, especially beginners, also opt for the arbitrage strategy to stay afloat in the market and make money over time.