What is Hedging?
Hedging is a process that investors use to protect their finances from any risks. In other words, hedging is the process that investors use to mitigate their risks. They do so to reduce the chances of losses or offset their assets against the losses. Hedging is also useful in limiting the loss the investors make and introduce certainty to a transaction.
Hedging is a common practice in many industries. Any entity, including individuals, companies, organizations, etc., can use hedging as a method to reduce their risks. There are many techniques that are available when hedging against risks. Usually, these techniques involve using financial instruments that derive their value from an underlying security or asset. These are known as derivatives.
However, there are some disadvantages to hedging. Since hedging is a process used to reduce risks, it can also result in the loss of potential rewards. Entities that use hedging also lose their profits while they choose certainty over their returns. Usually, hedging involves two parties. One party accepts the risks of the other party while also benefiting from the transaction in several ways.
Hedging is common through the use of derivatives. These include options, futures, forward contracts, and swaps. One technique common among these is interest rate swaps.
What is an Interest Rate Swap?
An interest rate swap is a financial derivative that investors use to swap their interest payments with another party. Interest rate swaps are necessary for mitigating the risks involved with floating interest rate instruments. Usually, these contracts involve the exchange of a floating-rate debt instrument with a fixed-rate instrument.
With interest rate swaps, participants can mitigate the risks associated with their debt instruments. For most participants, interest rate swaps are a powerful hedging technique. When the interest rates in the market are uncertain or volatile, entities can use interest rate swap hedging to achieve certain interest payments.
Like every other hedging technique, interest rate swaps include at least two participants. One party usually accepts to pay a floating rate interest on the other party’s behalf. In exchange, the opposite party gets to make a fixed interest payment. There are several terms that both parties define in these contracts to ensure a smooth process.
Usually, both parties decide on the principal amount of the swap. Once they do so, they define the rates for the contract. The contract will also include the length for which the swap will be applicable and any other terms. Once both parties agree to it, they will sign the contract, making the contract effective.
Interest Rate Swap Hedging Example
A company, ABC Co., has a floating interest rate loan with a principal amount of $1 million. The company expects interest rates in the market to increase in the future. Therefore, it wants to hedge against the risk of losses in the future. Another company, XYZ Co., has a fixed interest rate loan with the same principal amount.
Both companies agree to enter an interest rate swap contract. With this contract, ABC Co. will be responsible for paying XYZ Co.’s interest payments and vice versa. In case the market interest rates increase, ABC Co. will pay a fixed interest payment and benefit from it. Contrarily, if the market interest rates drop, XYZ Co. will profit.
Through the interest rate swap contract, ABC Co. can hedge its interest rate risks. For XYZ Co., the swap contract is also beneficial. In case the market interest rates drop, the company will get favourable payment terms. Therefore, both companies can use interest rate swaps to hedge against the risks of rising interest payments.
Hedging is a process that entities, whether individuals or companies, use to mitigate risks. There are many techniques that are available to hedge against those risks. One of these includes interest rate swaps. These are contracts that participants use to mitigate the risks associated with interest rates.