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Hedging is a technique that investors use to mitigate any specific risks that they face with investments. Usually, it includes investing in derivatives to counterbalance the adverse impacts of any risks. There are many types of hedge instruments that investors may use for that purpose. For example, investors can use options, futures, swaps, etc., to mitigate their investment risks.
With hedging, investors take an opposite position to their current one. This way, they don’t have to suffer in case their investments perform adversely. Due to the number of options available to investors, there are several techniques that they can use during this process. These may include static or dynamic hedging. Both of these are different in various regards.
What is Static Hedging?
As mentioned, investors use a hedge to protect against any risks facing a specific investment. However, once investors hedge against those risks, some variables may change. A static hedge is a type of hedge that does not require investors to rebalance it actively. It means that investors do not take steps to adjust these hedges when some characteristics of their securities change.
Static hedges have a finite life period. While investors may need to adjust these hedges when their investments expire or mature, they do not do it as often as dynamic hedges. Usually, this rebalancing occurs after long intervals. One example of a static hedge is a future in which investors can hedge a position against an investment. Through these derivatives, investors can hedge against price or foreign exchange risks.
What is a Dynamic Hedge?
A dynamic hedge is a type of hedge that requires investors to rebalance actively. It means that as the factors concerning their portfolios alter, investors will need to adjust their position. Dynamic hedges may require more regular rebalancing compared to static hedges. In some cases, dynamic hedges may be the only option for investors as static hedges may not cover the risks.
Dynamic hedges look at several factors when considering rebalancing. The most common of these is the price of an investor’s portfolio. However, other factors may also require attention, such as volatility. One example of a dynamic hedge is options. Investors can use these to hedge against several risks. However, these require regular rebalancing to be effective.
What is the difference between Static and Dynamic Hedging?
As mentioned above, the primary difference between both hedges is the need for investors to rebalance them. Static hedges do not require regular rebalancing. In some cases, these may not be effective for longer periods. Similarly, investors will need to rebalance eventually. However, this rebalancing occurs after a long period of time.
Dynamic hedges, on the other hand, take a more active approach towards hedging. It requires investors to monitor their investments and adjust their hedge instruments accordingly. Despite being more active, it does not imply that dynamic hedges are more effective. During high volatility periods, they may not be as effective in hedging either.
Conclusion
Hedging is a process through which investors can mitigate the risks associated with their investments. There are several approaches to hedging, which may be more applicable to specific situations. Static hedges do not require investors to rebalance their hedge instruments regularly. However, with dynamic hedges, the process occurs more actively.
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