Everything You Wanted to Know About HEDGING

The purpose of hedging is to reduce the risk of price movements that might turn out adverse at any point of the trade.
Written by
Danish Mohd
Published on
September 25, 2023

What is hedging?

Hedging is a savior tactic used by investors while performing trade in the market. Hedging can simply be explained by reducing the price risk of an existing position by taking an offsetting position in an asset or investment.

The purpose of hedging is to reduce the risk of price movements that might turn out adverse at any point of the trade.

This strategy proves to be highly efficient in lowering and limiting the risk when it comes to financial assets. Investors always intend to play safe, and no one manifests to face losses; thus, hedging acts as a cushion to marginalize the risk factor while aiming for high profits.

Financial instruments known as derivatives are used in the process of hedging. Options and futures are the two most commonly used derivatives in hedging.

It can also be said that "investors hedge one investment by making another. "If the investment you are hedging against makes money, you will have normally reduced the profit that you could have made.

But if the investment loses money, your hedge, if successful, will reduce that loss.

Hedging is performed almost everywhere, be it consciously or unconsciously For example, when an owner of an office opts for insurance, it’s the hedging against fires, break-ins, natural disasters, or any other unpredictable situation. 

Capitals, futures, and debentures can be best played along to range the risk factor. Hedging is used and handled differently in different situations calculating the pointers such as profitability and risk. 

As many are the endless benefits of this option to safeguard, it also has its limitations, which need a constant eye. The idea of hedging is expected to eat up a lot of profit in costing and planning.

It offers little to no benefit in case the market is doing well and upscaling. Hedging to be accurate in trading strategies requires immense skills and experience.

Hedging, at times, can turn out to be a long and complicated path to follow when it's about short-term or day trades.

As risk and profit always go hand in hand, the risk-bearing which comes with hedging would also kill the profit share. 

It is noticed that most buy-and-hold investors oversee the short-term fluctuations, longing for higher profits. For these investors, they let their investment grow with the market overall, as there is little point in engaging in hedging. 


Types of Hedging

One can opt for numerous types of hedging practices according to the investment situation. 

Forward exchange contract for currencies

The clear idea for the forward exchange contract is to fix the exchange rate prior in order to avoid the higher exchange rate risk.

A Forward exchange contract for currencies is a contract between the bank and its potential customers between whom the currencies would be exchanged as it would take place on a future date but at a rate of exchange in advance mentioned under the contract. 

Forward Exchange Contract for interest

suggests no change in the interest rate in the future. The parties undersign a bond. Bank and a Customer to pay or receive the difference, also known as the settlement money, between an agreed fixed rate (FRA rate)

Currency future contracts

Currency futures are the future contracts for currencies specifying the price of exchanging one currency for another. The spot rate is the one fixed rate for currency contacts.

Currency futures are used to hedge the risk of receiving payments in foreign currency spot rates. Currency futures are used to hedge the risk of receiving payments in a foreign currency.

Short Straddles on equities or indexes

Short straddles are when the investors can trade along the call option and can put the option at the same strike and underlying the same expiration.

A short straddle profits from an underlying lack of volatility in the asset's price. This is usually used to bid time, and the traders are the proficient masters to act on the same. 

Commodity futures contracts for hedging physical positions

Other much-optimized futures are asset classes used as risk bearers, that is, hedges.

Although prevention of risk and loss is a human courtesy, it shouldn't be at the stake of profit. As investors grow in the finance market, one needs to be highly self-predictable rather than relying on such prompts as hedging. However, if used wisely, hedging can prove to be a boost in profits while minimizing the risks 

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