Hedging in investments is the most peculiar way of attempting to ensure against a negative event. Anything can happen in future, being securedis the basic concept of this subject Hedging.
It is an investment intended to counterbalance any loss or gain that may occur to an individual or a company’s investment. Let me slow down; it’s a system to ensure you walk thesafest path, always.
The Baker’s Problem
It’s rather a simple concept, like playing a gambling game; let’s say you own a famous bakery in New York. Your crown jewel is the infamous Olive bread with shiny chunks of Kalamata olives. This Olivebread smells so good that customers from around New York come to your bakery exclusively for your Olive bread.
One day you hear speculations in the air that there will be a raise in price of wheat in coming months. As a baker, you can imagine the sway of this price increase in near future and the future of your career as a baker.
With Increase in wheat price, you will have to increase the price of your Olive Breads to make both ends meet. This change will set off a chain reaction, and you fear of losing your long time customers.
Now to secure your customers you will have to secure a good price on wheat for coming months, this is possible by hedging a contract with the wheat farming company. You can purchase a contract which will give you Wheat for coming months for a current price of an agreed future price.
In future, this could lead you to two possible outcomes:
- Price of Wheat becomes higher than the price on Contract
- The price of Wheat is less than the price on Contract.
If the price of Wheat is higher than the price on Contract, then you have made a very good decision by hedging a contract. You have saved potential customers from having to eat normal bread. If theprice of Wheat is less than theprice on contract, you might have made a mistake and curse those speculations, But still, you have successfully retained your customers, theprice of your Olive bread will remain same.
What are the risks?
Taking risks shows confidence and helps us stand out in thecrowd. We learn from risks we take, and those lessons may lead us on a much important path. Find one common word that connects all these four words.
- Volatility
- Supply and Demand
- Economic Cycles
- Force Majeure
Financial terms can be dodgy and means different things to different people in different situations, In common; these words only mean one thing “Risksâ€.
Hedging is a necessary risk in every successful organisation. This system is just like Arbitrage, which helps you with risk-free profit and does not give you a negative impact.
Types of Hedging
Many types of strategies are implemented to minimise risks. As the name denotes, the risk factor is minimised with the help of Financial Instruments such as derivatives. Some of the Common techniques are listed below:
Options
Let’s assume you own shares of a specific company, and you believe strongly in the long run profit of the company. However, you are concerned about its short-term losses. To protect yourself from these Short-term losses you could buy a put option on the company. This Options method will allow you to sell at a specific rate anytime you wanted to.
Futures
In this scenario you have a company that relies on a specific commodity, you feel insecure on the price of the commodity. If the price of the commodity skyrocketed your company and your future is in trouble as this would eat into your profit margins. To avoid this scenario, you could enter into a futures contract with the said Commodity Company to buy the commodity at a specific price at a set date in the future.
Natural
These types do not include foreign financial systems or derivatives. It is an investment that reduces the risk by corresponding cash flow, for example, A company opens an ancillary in another country and borrows local currency to finance its financial needs. Even though the local interest may be more, by matching the debt payments to the expected revenue, the parent company can reduce its foreign currency exposure.
Tracker
The pre-purchase method is used to handle this type. Coal purchase is one of the Best examples to explain this phenomenon. Minimising the open position as the maturity date comes closer. For Example, a coal commodity company will purchase half of the estimated coal in summer, Another Quarter in autumn and the remaining in winter. The closer the winter comes the better the forecast.
Emotional
This part is especially for people who would say “I would never bet against my team, Not in a thousand years†When you simply put your Emotions aside and work purely with numbers and cherish on the outcome regardless of the team name you are hedging emotionally.
These types are common among game bets, when you are in the arena with your home team, and they are losing, simply bet on the winning team. You might after all get the satisfaction that you won the bet money,
The Downside
Like purchasing car insurance, you cannot prevent the accident itself, but you simply reduce the negative impact from that incident. Nevertheless, you will need to purchase the car insurance if you wanted to reduce the negative impact in the first place.
As there is either a neutral or positive effect, one of the notable downsides is its financial position. Every hedge has a cost;it is best to think deeply before hedging if the risk is worth.
It is a strategy that helps an investor reduce the risk he takes on investment when comparing this with Insurance; Insurance is far more precise. All your losses with minor deviations will be paid off by the insurance company. Although risk managers are trying to evolve a perfect hedge, practical implementations are rather vague.