Definition of Hedging
Hedging is a popular risk management tool used by Investors whether individual or Corporates as well as by Financial Institutions to manage their Risk (especially Market Risk and Credit Risk) arising out of their investment and credit decisions. In other words, hedging acts as insurance against potential losses arising out of adverse movements leading to deterioration in the value of an investment.
Hedging is a part and parcel of risk management and from simple hedging tools to advanced hedging strategies are used by Individuals to big corporations to manage their risk. An important thing to note here is that Hedging is never undertaken to make extra gains but to protect against potential losses and also using hedging tools will lead to reduced profits compared to without hedging tools as hedging comes with a cost for the business. Also, Hedging is not free but has a cost attached to it which also needs to be well understood and analyzed before one enters into hedging to reduce or minimize the risk of adverse events on the investments. It is pertinent to note here that hedging is not just confined to only Investments and big credit decisions undertaken by big organizations, financial institutions, and so on but is a part of an individual daily life where hedging is done to minimize risk.
How does Hedging Works?
Hedging involves taking an offsetting position in another asset with a negative correlation with the asset against which hedging is undertaken. To put it in simple words lets understand a bank buys a bond of Company XYZ which makes it entitled to receive fixed coupons and Principal payment at the end of the tenure of such bonds. However, the bank will lose the whole of the coupons and principal in case Company XYZ defaults or say goes bankrupt. To hedge this risk bank buys a Credit default swap (CDS) against such company by paying the premium amount to the CDS issuer, which entitles the bank to receive the proceeds from the CDS issuer in case the company defaults. Thus hedging, as a risk management strategy, helps in offsetting the loss in investment in Bonds by offsetting gain through receipt of proceeds from the CDS issuer.
Examples of Hedging
Let’s understand Hedging with the help of a simple example.
ABC Limited is in the business of export of software systems and usually receive payment in USD. The company has a payment receipt cycle of six months which means that services delivered on 01.01.2020 will be paid on 30.06.2020. The company is having receivables amounting to $100000 as on 01.01.2020 when the USD/INR rate is 73. The company expects the rupee to appreciate against the dollar (an appreciation of rupee against dollar implies that the price 73 as of now will fall further leading to lower rupee inflow for the business) in the coming months and as such decided to hedge its dollar receivables by entering into a forward contract of six-month expiry at USD/INR rate of 73.70.
Thus by entering into a Forward Contract ( Hedging tool) ABC limited removed its foreign exchange risk arising out of change in the value of USD/INR, however, it is pertinent to note that by entering into a forward contract at the negotiated rate which in this case is 73.70, ABC Limited has firstly incurred a cost of hedging by paying the premium and secondly it has capped the profit that would have resulted in case after six months USD/INR goes beyond 73.70 ( as ABC Limited will get only 73.70 as USD/INR rate).
Types of Hedging
Hedging can be of different types; however, all have the same objective to minimize risk and protect gains to some extent. The popular hedging types are namely:
- Forward Contracts: This is a customized OTC (Over the counter) bilateral contract with customized terms and conditions agreeable to the two counterparties which have entered into for hedging. It is possible that one of the two counterparties may not be a hedger but a speculator as well. These types of contracts carry a high level of counterparty credit risk.
- Futures Contract: This is a standardized non-customized futures contract with one counterparty being a Centralized Counterparty (CCP). For each Futures contract, the other counterparty is CCP. These contracts carry a limited level of counterparty credit risk due to the involvement of CCP in each contract and is a low-risk hedging strategy; however, it lacks in providing customized features due to its inherent standardized feature.
Strategies of Hedging
There are various Hedging strategies that investors and producers can opt for depending upon their ultimate objective and risk appetite. Also, Hedging strategies vary based on whether the same is undertaken in Futures, forwards or Options as all such have varied level of cost and strategies available and one need to opt for the one which is best suited to their needs.
Advantages of Hedging
Hedging offers multiple advantages. A few noteworthy are enumerated below:
- Hedging helps in the reduction of risk for the business.
- Hedging help business to focus on its strength areas and mitigate other risks which are better managed externally.
- Hedging involves the uses of derivative which normally can be either Options and/or Futures or a combination of both as well.
Disadvantages of Hedging
Hedging despite its multiple advantages suffers from certain shortcomings as enumerated below:
- Hedging is a costly affair which means it has a cost and in some cases, the cost outrun the benefits as well which at times brings to the fundamental question of whether hedging fully is advisable or a partial hedge and partial risk position should be kept by the business.
- Hedging leads to reduced profitability or capping the profit potential for the business.
- Hedging is not available for all types of investments and asset classes. Also identifying a perfect hedge for each asset class is a big challenge and it has been observed in many instances that correlation changes dramatically in case of catastrophic events when hedging was most needed as a risk management tool.
- Hedging requires the use of specialized skills and manpower and in the absence sometimes results in wrong-way risk for the business.
This is a guide to Hedging. Here we also discuss the definition and how does hedging works? along with advantages and disadvantages. You may also have a look at the following articles to learn more –