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All you want to know about hedging

Last updated on: August 17, 2009 12:35 IST

With an increasing number of people becoming interested in finance, and taking the plunge in stock markets, understanding certain financial jargons is of utmost importance.

Those of you who frequently dabble in stock markets have often come across the term 'hedging'. Read on to find out all about 'hedging'...

What is hedging?

Hedging is something that we do in our day-to-day lives. One example is our parents getting us vaccinated against certain diseases. This ensures that the diseases don't have an adverse impact on our health.

Another example is buying insurance. We buy insurance so that if and when a medical emergency arises, the financial aspects of the unforeseen event are to a great extent taken care of.

This does not necessarily stop the event from happening, but it just ensures that the impact of that event on our lives is minimal.

Risk and returns go hand-in-hand. We must always remember that behind every high return, there lurks the danger of risk, which is ready to pounce at a slightest miscalculation.

Hedging refers to a method of reducing the risk of loss caused by price fluctuation. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. Portfolio managers and corporations use hedging techniques to reduce their exposure to various risks. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

What are hedging strategies?

Options - The right, but not the obligation, to buy or sell a specified quantity of the underlying asset at a fixed price (called exercise price), on or before the expiration date.

There are two kinds of options. There are two sub-types - call (right to buy) and put (right to sell).

Futures - A contractual agreement, made only on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in future.

How is hedging done?

Let's look at one example using the futures strategy.

For a kitchen equipment manufacturer, steel is an essential raw material. The exporter enters into an agreement to export kitchen utensils and other equipment, three months hence to dealers in the American market.

This means that a contractual obligation has been fixed at the time of signing the contract for exports.

The kitchen equipment manufacturer is now exposed to the risk of rising steel prices. In order to hedge against price risk, the kitchen equipment manufacturer can buy futures contracts on steel, which will mature three months later.

In case steel prices rise, the manufacturer is protected from the risk of loss.

Now, let's analyse the different scenarios:

If steel prices rise, it will lead to an increase in the value of the futures contract, which the kitchen equipment manufacturer has bought. Therefore he earns a profit in his futures transaction. But the manufacturer has to buy steel in the physical market in order to meet his export obligation. Since steel prices have risen he faces a loss in the physical market.

But his losses will be offset by his gains in the futures market. The kitchen equipment manufacturer can recover the loss incurred in the physical market by selling the futures contract, in which he has an open position (called closing out, technically).

If steel prices fall, it will lead to erosion in the value of the futures contract, which the kitchen equipment manufacturer has bought. This way the manufacturer will incur a loss on his futures contract.

But the manufacturer has to buy steel in the physical market. Since steel prices have declined in the physical market, he gains. Therefore, the losses incurred in the futures market will be offset by the gains made in the physical market. This way one can hedge against possible losses arising from fluctuation in raw material prices.

One can hedge against interest rate and currency, too. Short selling is a hedging tool that can protect you from unnecessary risks.

A basic understanding of hedging strategies will definitely help you as an investor.

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