Hedging is often understood as insurance against risks. Hedging does mean insurance against any untoward incidents in the financial market, but it is not as simple as getting protection against negative impacts by just paying a premium.
How is hedging different from insurance?
In layman, language Hedging is definitely meant insurance against losses one might have to face while dealing in financial instruments. If we look at the nuances of hedging in the financial market, it is a lot more complicated than insurance. The process of insurance is less time consuming and a lot easier.
For instance fire insurance. We just need to find the right policy and pay the premium periodically. This will take care of protections against any fire accidents on the assets we have insured.
Hedging is lot more complex task. In the financial market that is ever evolving and highly volatile, the investor needs protection against any potential losses caused by price fluctuations of the securities. The impact of the adverse price changes of the investments can be reduced through various hedging techniques. It is essentially managing the risks by picking the right mix of financial instruments that offset the loss caused by the price fluctuations.
Hedging – Is it a perfect science?
Hedging is performed with the help of complex financial instruments called derivatives. Derivative, as the name suggests, derives its value from another commodity or underlying asset. For example – A trader dealing with corn is worried about the increase in corn prices. He can enter into a forward contract to buy corn at a specific price in future. In the event of price rise, he is unaffected by it as he can buy it at the strike price agreed upon. But in case the price falls he will still have to buy corn at the strike price itself. The success of the hedge is not guaranteed. It only helps in offsetting the risk but does not guarantee a profit. It does not qualify to be a perfect science due to the unpredictability involved in the success of hedges.
Hedging in the financial scenario is usually performed by selecting two financial instruments which have an inverse relationship. The investors will have to select the investments strategically to be able to benefit from the hedging proposal.
Who performs the task of hedging?
One needs to understand the nitty-gritty’s of the various financial instruments to perform hedging. Individual investors are less likely to perform this as they might not necessarily be worried about the short-term price fluctuations. It requires the skill of an investment manager who has a fair amount of experience dealing with various financial instruments. Even though the task of hedging is best done by the professionals in this field, it is important that the investors have some idea of this complex process.
Hedging also comes with a cost. It will definitely eat into the investor’s profits. The investor needs to decide if he needs more profit or protection against any contingent losses.