What is hedging?
So often we hear that hedging reduces the risk of price fluctuations. And, of course, this topic is primarily interested in financiers and people who create their business in the market and investors. So, in this article, we will more thoroughly understand what hedging is and what its features are.
To begin with, we note that hedging is certain measures that have the purpose of insuring risks in financial markets. In simple terms, this is a kind of agreement on the purchase and sale of a product in the future. Do not be surprised if you hear the phrase “hedging currency risks,” because insurance for currency is also made. The thing is that the world is constantly fluctuating market prices and this is not news. Therefore, taking into account the market price, which may be in the future, both parties allegedly insure themselves against unpleasant surprises.
Recall that the hedging is paid, so if in the future there are no unforeseen situations, we will lose part of the profits, but, on the contrary, in another case, we will keep this profit.
We note immediately that there are two concepts in this business with which hedgers operate - financiers who insure risks. The first is futures - derivatives, which oblige both parties to make a deal in the future at a pre-agreed price. Second, options are derivatives, which make it possible to make a deal in the future at a predetermined price, but is not mandatory.
So, here are some examples:
- You are a shareholder of a company, and you expect the share to grow in the future. But there is the possibility that the price of it will fall. Therefore, you are insured against falling prices. To do this, you get an option with the right to sell this stock at a certain price. And if the price does fall in the future, you can still sell the stock at a predetermined price. But recall that you have the right to do so, but do not undertake to comply with it.
- You are the director of a company that produces beer and, of course, you constantly need to buy barley. In this case, expecting that the price of barley may rise, your company purchases futures or it is also called
a futures contract, where the price that you will pay for barley in the future will be indicated. And it is very profitable, if the price of barley does soar, but if it stays the same or goes down, you will be at a loss as you still have to pay the agreed price.
So now let's see what risk hedging methods exist today:
- Derivatives. This hedging, an example of which we cited above, and described in detail about it.
- Immunization portfolio. This method is designed to invest. This procedure involves hedging one particular spot asset through a completely different spot asset that has a high correlation of price sensitivity.
So now you know what hedging is and what its goals are for.