Definition of Hedging
Hedging is a famous risk management tool used by investors, whether individuals or corporations and institutions, to manage their risk (especially Market Risk and Credit Risk) arising from 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 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. Also, using hedging tools will lead to reduced profits compared to those without hedging tools, as hedging comes with a cost for the business. Also, it 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 confined to investments and big credit decisions undertaken by big organizations, financial institutions, etc. It is a part of an individual daily life where hedging is done to minimize risk.
How does hedging work?
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, let’s 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 if Company XYZ defaults or goes bankrupt. To hedge this risk bank buys a Credit default swap (CDS) against the 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, as a risk management strategy, it helps offset the loss in investment in Bonds by offsetting gain through receipt of proceeds from the CDS issuer.
Examples of Hedging
Let’s understand it with the help of a simple example.
ABC Limited is in the business of exporting software systems and usually receives payment in USD. The company has a payment receipt cycle of six months, meaning services delivered on 01.01.2020 will be paid on 30.06.2020. The company has receivables amounting to $100000 as of 01.01.2020 when the USD/INR rate is 73. The company expects the rupee to appreciate against the dollar (an appreciation of the rupee against the dollar implies that the price of 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
It 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 counter) bilateral contract with customized terms and conditions agreeable to the two counterparties which have entered into 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 are a low-risk hedging strategy; however, it lacks customized features due to its inherent, standardized part.
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 costs and strategies available, and one must opt for the one best suited to their needs.
It offers multiple advantages. A few noteworthy are enumerated below:
- It helps in the reduction of risk for the business.
- It helps companies focus on their strengths and better manage other risks externally.
- It involves using derivatives, which generally can be either Options and/or Futures or a combination of both.
Despite its multiple advantages suffers from certain shortcomings, as enumerated below:
- It is a costly affair which means it has a cost. In some cases, the cost outruns the benefits, sometimes raising whether it is advisable or whether the business should keep a partial hedge and partial risk position.
- It leads to reduced profitability or capping the profit potential for the business.
- It is not available for all types of investments and asset classes. Also, identifying a perfect hedge for each asset class is a big challenge. In many instances, correlation changed dramatically in case of catastrophic events when hedging was most needed as a risk management tool.
- It 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, how hedging works, and its advantages and disadvantages. You may also have a look at the following articles to learn more –