Hedging is the use of an instrument to reduce risk and protect capital from unfavorable market factors. Usually hedging is carried out with the aim of insuring against price changes by entering into transactions in the derivatives market.
There are two types of hedging: the buyers hedge and the sellers hedge. When a company plans to buy goods and wants to reduce the risk associated with a price increase (long hedge) – it’s called buyer’s (investor’s) hedge. It means that the buyers (investors) hedge is used to insure the buyers possible risks associated with a likely price increase or a potential deterioration in terms of the transaction. If during planning the purchase of a consignment of goods the company wants to reduce the risk attached to the possibility of a decrease in price (short hedge), it’s called Seller’s hedge. Hereby the sellers hedge is used to insure the sellers risks associated with a possible price drop or deterioration in the terms of the transaction (for example, insufficient demand).
There is a distinction between direct hedging - the item is the same as the underlying hedged asset and cross-hedging – in this case the hedged item is not the same as the underlying asset.
It is possible to hedge with forward and futures contracts, in this case the profits or losses in the forward / futures market cover the losses or profit in the cash market. You can hedge existing positions by entering into put options - to sell at a predetermined price and call - to buy. You can also use other derivative financial instruments for hedging.
Example of hedging risk for a bank:
A client contacts the bank with a desire to open a deposit after a certain time at a predetermined interest rate for a certain period, for example, for a year. In fact, this is the conclusion of a forward contract with a client. At the same time, if this forward is not hedged, then the bank may face a decrease in interest rates on deposits by the time the client is ready to open a deposit, and will incur direct losses. To hedge such a position, you can sell a derivative financial instrument, for example, FRA (Forward Rate Agreement). In this case, the dealer will compensate the bank for losses in case of a decrease in interest rates on the market. The bank, in its turn, will place on the interbank market the amount for which the client opened the deposit and the FRA payment at the current market rate for the same period as the action of the clients deposit, thus avoiding or minimizing losses.
An example of a risk hedge for a private investor:
Let’s suppose a private investor purchased shares of a company, but there is a risk that the prices for the companys products will decrease in the future and the shares will fall. For hedging, a private investor can open positions in futures for the products of this company. In this case, when the stock falls, the private investor will be compensated for their losses through futures. Most often, such hedging operations are performed when buying shares in oil companies.
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