What is hedging?
Hedging is the process of taking on offsetting positions in an effort to minimize exposure to risk. For example, if you are long a stock, you might hedge your position by buying put options. This way, if the stock price falls, you can still sell your shares at the strike price of the put option.
Hedging can be used to protect against a wide variety of risks, including interest rate risk, foreign exchange risk, and commodity price risk. In the financial world, hedging is a very important tool for managing risk.
The practice by which a business or investor limits risk by taking positions that tend to offset each other. For example, a business stands to lose money if the price of a commodity it holds declines, but it can offset this risk by agreeing to sell a specified amount of the commodity at a set price at some point in the future.
Hedging is a risk management technique that generally involves adding an opposite exposure to an existing risk, in the expectation that variations in the two items will cancel out – in whole or in part – to reduce the net variability in the overall hedged position.
Traditionally, hedging referred to using derivative financial instruments (such as forward contracts, futures contracts or options) or other techniques to reduce the impact of fluctuations in such factors as the market price of credit, foreign exchange rates, or commodity prices on its profits or corporate value.
For example, entering a foreign exchange forward contract to sell an expected future foreign currency receipt.
Other techniques include operational or structural responses, for example re-locating manufacturing or assembly to align the currencies of costs with revenues.
Following such successful structuring, the organisation may then be said to be ‘naturally’ hedged.
Another form of hedging is diversification.
How does hedging work?
Hedging is a way to reduce risks by taking on additional exposure to an asset that has already been purchased. For example, if you buy a stock at $100, you might hedge by buying a put option with a strike price of $90. This reduces your risk because if the price drops below $90 per share, you can always sell your stock for $90 per share.
Hedging is also commonly used by traders who trade futures contracts. Futures contracts are financial instruments that allow buyers and sellers to agree on the future value of an underlying asset. For example, a farmer might sell his crops to a grain company in exchange for a contract that guarantees him a certain price for his crop. If the price of corn rises above the guaranteed price, he will sell at the agreed-upon price. However, if the price falls below the guaranteed price, he earns money from the hedge.
There are three main types of hedging instruments: futures, forwards, and options. Futures are contracts where the buyer agrees to buy an asset at a fixed price on a specified date in the future. Forward contracts are similar except that the seller agrees to deliver the asset at a fixed price in the future. Options are contracts where the buyer has the right to purchase the asset at a set price within a specified period of time.
Different types of hedging
There are two main types of hedging:
-Static hedging: these are hedges that are put in place and then held for the duration of the exposure. For example, if you are worried about interest rates rising, you might enter into a swap agreement where you exchange fixed payments for variable payments.
-Dynamic hedging: these are hedges that are constantly adjusted in order to maintain an optimal level of protection. For example, if you are long a stock, you might buy put options and sell call options. As the stock price changes, you will need to adjust your position in order to keep the hedge effective.