The term ‘Hedging’ refers to the protection from loss of capital, investment or savings, property due to uncertain events such as depreciation, inflation, fluctuation in prices or a sudden accident.
In this article, we will discuss the following topics.
- What is Hedging in Finance? (with examples)
- What is Hedging in Forex?
- Hedging through Stock Futures
- Hedging through Index Futures
- Hedging through Commodity Futures
Table of Contents
What is Hedging in Finance?
Hedging is the process of minimising or eliminating the risks associated with the price movement of shares or stocks, currency and commodities or precious metals.
In other words, Hedging is the risk management process through which an investor can protect or offset his investments/ savings due to an uncertain fluctuation of the price of financial securities in the financial market.
In fact, Hedging is not limited to the financial market or the stock market, it is wildly used in general lifestyles.
Let us understand the term Hedging through an example in general life.
Nowadays most of the people insurers their cars to minimize the uncertain expenditure due to sudden accident or thefts.
People get their life insurance done to assure the continuous income which can be stopped due to death/ sudden death of the person. Thus to insure himself with a life insurance cover one can hedge the risk of a shortage of money.
People purchase health insurance to protect unexpected expenses because of any severe diseases.
Hedging through Stock Future:
Suppose Mr A had purchased the 500 shares of L&T Ltd at the price of Rs 1000/- per share with the perspective of long term investment. Thus he made an investment of Rs 5,00,000/- in L&T Ltd.
Now Mr A prevails the price of shares of L&T Ltd is going to decline in the next three months. Obviously, he would want to offset or minimize the risk of loss due to price downfall in shares price. Hence, he will purchase an options contract (Right to sell the stock of L&T at the price of Rs. 1000/-) by which he will still be eligible to sell the shares at the price of Rs 1,000 irrespective of shares price in the spot market after three months.
Thus in this ways, Mr A can minimize or eliminate the loss due to a price decrease in the shares of L&T Ltd.
This process of eliminating the risk of due to movements in the stock price is called as Hedging.
What is Hedging in Forex?
There is always a risk of loss in international trade (export-Import business) due to fluctuation in the currency exchange rate. Therefore exporter or importer has to hedge the risks associated with the movement of the currency exchange rate.
If you are an importer and imported some goods or services worth $ 50,000 from the United States. Suppose exporter offered you a credit up to 6 months. Obviously, you would like to utilise those credit though at the same time you might be at risk because the price of dollars is not going to same as of now. It might be an increase or decrease in terms of the local denomination.
Hence to avoid or offset these risk traders usually take the help of derivatives. According to the situation, the traders may take a long term or short term to hedge the risk of loss due to price fluctuation in currency exchange rates.
Hedging through Commodities future:
The commodity refers to food grain, oil, precious metals such as gold, silver. These commodities are also in the risk of loss because of price declines.
Suppose Mr A deals in copper and has ready stock of copper 10 metric ton at the price of Rs 400/- and the price of copper is prevailed to decrease in future. Obviously, Mr A would like to avoid this loss due to the price decline in the copper price.
Therefore, to hedge the risk he needs future contract where the underlying asset is a commodity. Thus Mr A has to enter in a commodity futures contract to hedge the risk where the underlying assets are copper. This may be termed as a copper future contract.
Hedging through Index Future:
Hedging can be managed through index futures as well but in those cases where the future contract of specific shares is not available in the derivative market.
There are plenty of shares of various companies listed in the stock market but future contracts of each stock can not be available in the derivative market. Suppose you are holding the stock of XYZ Ltd of worth Rs 1,00,000 and the price of the same share is expected to decline in upcoming days but future
contracts are not listed in future markets.
So what can you do to avoid those risk, the solution is to hedge with index future of stock exchange (NIFTY/ SENSEX) itself.
Thus Hedging is an important concept of the financial market we can correlate it with the real-life example with the financial hedging. Therefore, we can secure our investment/ savings with the help of derivatives in the stock market even in the environment of a declining market.
The following concept might also be beneficial for you.