Understanding Hedging

In finance, hedging is used to minimize risks by taking position in one market to offset exposure to price fluctuations in some other market. There are many financial vehicles to do this like options, insurance policies, forward contracts etc.

Hedging is a day-to-day task and everybody is engaged in it. For example when you take out insurance to minimize the risk that an injury will reduce your income, or you buy life insurance to support your family in the case of your death then this is a hedge. Although hedging is defined as an investment taken out to limit the risk of another investment, insurance is an example of real world.

To understand hedging let us take example of two companies say company A and company B from the same industry producing product X. Now company A produces X that is twice as good as its nearest competitor, so you think that A’s share value will rise over the next month. But the industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this you want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on company A while shorting company B. The value of the shares involved will be say Rs. 1, 00,000 for each company.

Now, how will this help you? If the industry as a whole goes up, you make profit on company A, but lose on B. But if the industry takes a hit you lose money on A and make on B.

This is also called pairs trading and it helps investors minimize risk in volatile industries.

Leave a Reply

Your email address will not be published. Required fields are marked *