Hedge
Key Highlights
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In finance, a hedge is an investment or strategy used to reduce or offset the risk of adverse price movements in an asset.
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Types of hedges includes natural and financial hedge.
What is Hedge?
In finance, a hedge is an investment or strategy used to reduce or offset the risk of adverse price movements in an asset. Think of it as insurance for your investments - you make a second investment to protect yourself if your first one loses value.
Purpose of Hedging
The main goal of hedging is risk management, not profit. It’s used to:
- Minimize losses due to volatility
- Protect against market fluctuations
- Ensure predictable outcomes in uncertain environments
How It Works – Simple Example
Suppose an Indian company expects to receive $1 million in three months and is worried that the USD/INR exchange rate might fall. To hedge this risk, it enters into a forward contract to lock in the current rate. This way, even if the rupee strengthens, the company is protected.
Types of Hedges
1. Natural Hedge: Reducing risk by operating in a way that automatically offsets exposure.
Example: A company earning in USD and incurring costs in USD.
2. Financial Hedge: Using financial instruments to protect against risks.
Example: Buying a put option on a stock you own.
Common Hedging Tools
| Hedging Instrument | Used For | Example |
|---|---|---|
| Forward Contracts | Currency, commodity, interest rate | Lock exchange rates |
| Futures Contracts | Commodities, indices | Lock prices of oil or wheat |
| Options Contracts | Stocks, currencies, commodities | Protect against downside loss |
| Swaps | Interest rates, currencies | Exchange fixed and floating interest |
| Short Selling | Equity markets | Protect long positions |
Hedging in the Indian Context
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Importers/Exporters hedge against currency risk using forwards or currency options.
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Farmers hedge future prices of crops using commodity futures on exchanges like MCX.
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Stock investors hedge their portfolios using index options like Nifty puts.
Limitations of Hedging
- It may reduce potential gains
- Involves costs (like premiums in options)\
- Complexity increases with sophisticated instruments