What is hedging?

Hello guys, the topic for today’s article is Hedging. I know there are many people who have heard this term but the next question pops to them is “What is Hedging in stock market?” I will take you through the basics of Hedging in this topic so that you can talk confidently about Hedging with your peers.

What is Hedging?

Hedging is nothing but a strategy adopted by investors to avoid any probable loss on their investments. It is a practice by investors to safeguard their investments from unpredictable market fluctuations.

In today’s time, unpredictability is only a predictable factor. To avoid any huge loss from volatile markets, investors use hedging as a tool for their investment. In short, hedging will not eliminate the risk associated with it but will surely mitigate it.

Hedging is not some foreign or novel activitybut is infact used by us from long time. A very common example of this is taking car insurance to hedge against the damage loss from the car.

Areas of Operation -Hedging

Hedging strategy is usually used in the following avenues

  1. Currency market
  2. Stock/Securities market
  3. Commodities
  4. Interest fluctuations
  5. Weather
What is Hedging?

Types of Hedging – What is Hedging in stock market?

Forward Contracts

A forward contract is a customizable contract between two parties who agree to buy or sell any commodity, currency, security, etc at a predetermined rate on a specific date. Usually this contract is a private contract and the details are usually known to the parties to the contract.

For E.g An entity who has sold goods and has billed $1000 to the customer. The exchange rate of $ on date of billing is Rs. 60. Now if the entity expects this rate to drop further then the entity will have to bear the exchange loss. So to avoid this loss, the entity will enter into a forward contract with the bank to sell $1000 on money receipt date at rate of Rs. 59 per $. The total loss in this case to the entity will be $1000*1 (60-59) and there would be some premium charges.

In case the exchange rate drops down by 59, then too the entity has covered itself by selling the dollars at Rs. 59 to bank.

Future contract

Future contract is a standardized contract by two independent parties to buy/sell an asset at specific date on a predetermined rate. It is used for various assets like commodity, currency, etc

The difference between Future and forward contracts is future contracts are traded in the market. These contracts are marked to market and are usually settled on day to day basis until the end of this contract.

Future contracts are highly liquid and less riskier than forward contract as they are traded in the market through clearing houses. These clearing houses guarantee the settlement of the contracts.

Money Market Instruments

These are the markets which involve short term buying, selling and borrowing is conducted. Usually these traded involve a period of less than one year. There are various contracts executed as money market like instruments for currencies, interests, covered call on equities, etc.

Strategies of Hedging – What is Hedging in stock market?

Diversification

The asset allocation strategy involves the diversification of your investments. As the saying goes, you should not put all your eggs in one basket. Similarly, you should diversify your investment portfolio to mitigate any risks.

Options

Have you heard about call or put options. I will cover this topic separately but to generalise they are derivatives which derive their value from underlying asset. Under this strategy, an investor purchases pull and call option both to reduce the loss on investment.

Structuring

This strategy involves investment in debt as well as derivatives/securities. Debt investments provide the stability and securities give the required growth.

Advantages of Hedging

  1. Hedging mitigates the risk involved with investments in an unpredictable market
  2. Improves the liquidity to the investor with certain returns
  3. Not a very costly affair as compared to notional losses.

Disadvantages of Hedging

  1. Though hedging mitigates the risk, it also limits the profit to the investor in case the market assumption is incorrect.
  2. Whatever be the market, you need to pay the premium and sometimes premium is more than the loss.
  3. Doesn’t guarantee the settlement in cases like forward contract as it is private agreement.

Even though there are advantages and disadvantages, hedging is definitely a tool used by many investors, fund manager, stockbrokers and security firms.

Hope this article has given you the basic information about hedging and has settled your question “What is hedging in stock market?” to a certain extent.

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