Hedging: What is hedging and why is it important to hedge?


Hedging is undoubtedly a vital part of the business. A business is exposed to various fluctuation risks namely foreign exchange risks, equity price fluctuations, interest rate fluctuations, and fluctuation in prices of the commodity. Hedging refers to a risk management strategy implemented to offset risks of losses in investments by assuming an opposite position in a linked asset. The diminution in risk owing to hedging also leads to a decrease in profits. For hedging, businesses need to pay premiums for getting protection and offsetting the risks.

If a company is a coffee maker, then the price of coffee and other associated products need to be closely monitored. Again, if a business depends on logistics and transportation, then the price of petrol needs to be watched closely. Foreign exchange is considered to be the largest market in the entire world and the trading volume daily is roughly 4 trillion to 5 trillion.

It is every so often an effective strategy for businesses to use hedging to defend from swings in the rate of exchange of a foreign nation they are currently investing in. The influence of fluctuations in market prices can have a shattering effect on a company’s profit. Therefore, businesses must protect the sensitivities of the core interactions.

Reasons for corporate hedging:

  • To curtail the corporate tax liability
  • To minimize the estimated costs of financial risks
  • To ameliorate differences and conflicts of interests between bondholders and shareholders
  • To boost co-ordination between investment and financing strategy
  • To optimize the overall value of the wealth portfolio of managers

Strategies of hedging

There are several effectual strategies of hedging to lessen the market risk, based on the asset or asset portfolio that is being hedged. The three most common hedging strategies namely, options, volatility indicators, and portfolio construction, are hereby discussed below:

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Options are an effective tool for hedging. Financiers intending to hedge a single stock with sound liquidity can purchase put options to shield against the risk of downslide. Essentially, puts acquire value when the underlying asset price decreases. The disadvantage of this strategy is the amount of premium that is to be paid to buy the put option. Purchased options tend to lose value as they approach the time of expiry. Vertical put spreads can lessen the amount of premium, however, they curb the amount of security. This stratagem is applicable for an individual stock, and financiers with diversified holdings cannot afford to hedge for each position.

Traders who intend to hedge a bigger and diversified portfolio of securities can utilize index options. Index options assess bigger stock market indexes, for example, Nasdaq. These indexes cover different sectors and are considered to be effective measures. It can be observed that stocks tend to be correlated and they move in a similar direction mainly during highly volatile situations. Traders can also hedge with index put options to slash risk.

Modern Portfolio Theory

Modern portfolio theory (abbreviated as MPT) is one of the most important tools that diversify to develop asset groups that lower volatility. MPT utilizes statistical measures to ascertain an efficient frontier for an estimated return rate against a set-out amount of risks. This concept scrutinizes the nature and degree of association between diverse assets, to craft an optimal portfolio. Different financial foundations have implemented MPT for the management of risks. The efficient frontier refers to a curved linear association between risk and return. Traders might have different degrees of risk tolerances and this theory can help in selecting a portfolio.

Volatility Index Indicator

Financiers can hedge using the volatility index indicator (referred to as VIX). VIX gauges the implied volatility of calls and puts on the indexes. This measure is also referred to as the fear gauge when VIX increases at a time of greater volatility. Exchange-traded funds (ETFs) also monitor the VIX. Financiers can also utilize ETF shares or options as a volatility-specific hedge. Certainly, whilst these tools are effective, they cannot lessen market risk.

Businesses mainly concentrate on a foreign exchange market. The main challenge is to learn effective ways to shield the company from this risk. They can choose to fix the price fluctuations by signing in an advance forward contract. Another alternative is to buy insurance policies, a call option, that permits movement in the expectation that the rate of exchange will improve and restricts the worst-case situation.

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