Hedging is an increasingly popular terms in the investment markets. Though not many people actually enter into hedging, most of them have already heard of the term. In fact, to protect yourself, you should at least have the very basic knowledge of hedging. Therefore, let us now know more about hedging and a way to better protect you from risks.
As we have mentioned, a hedge is a tool to reduce investment risk which is inherent to every investment. You can think in a way that a hedge is sort of an insurance for your investment. When the risks you are facing are getting bigger and bigger, you are more in need of hedging. There are many different types of hedging that suit your different types of investments. You can find forex trading swaps, interest rate swaps, futures hedging and hedging for stock prices as the common ones.
One thing you have to bear in mind is that hedging is not a tool to make money, but a tool to reduce risks. What you are doing when hedging is to invest in two products that have negative correlation. Say, when investment A is earning money for you, investment B on the other hand will be losing money for you. Your risk to lose money in investment B is hedged by the gain in investment A.
When the risk is higher, the earning or opportunity is likely to be higher, too. But, by hedging, the risk is reduced, therefore, the highest possible earning is also reduced. That means, when you are gaining on investment A, the gain is reduced by the loss in investment B. On the other hand, if you are making loss on investment A, the loss is reduced by gain in investment B.
Let us illustrate more clearly with an example of an interest rate swap. Assume that you have a loan from the bank of $50,000. You have to pay interest at the market rate for the loan. There is an interest rate risk that the interest rate goes up and you have to pay more interest. Therefore, you want to reduce your exposure to this interest rate risk and entered into an interest rate swap with the bank.
As there is a trade-off between risk and possible earnings, you can choose to what extend that you wish to reduce your risk. That means, you can enter into a $50,000 interest rate swap to minimize your risk or you can enter into a $25,000 interest rate swap to reduce part of your risk. For simplicity, we now assume you have entered into a $50,000 interest rate swap that you receive interest on a floating rate.
When the interest rate increases, you have to pay more interest for your loan, but on the other hand you receive more interest income. If the interest rate decreases, you can pay less interest for your loan, but your interest income also decreases. For explanation, hedging can be simple. But in real cases, you may not find that hedging is so perfect that all your risks can be completely eliminated. There’s probably no such thing as a perfect hedge. Unsettled transactions may result in great dissension.
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