What is Hedging ?

Hedging:

 It’s a technique used to mitigate risk. Hedging provides insurance against some loss that may occur.

 Simple Example: Suppose you bought a car. What is risk involved?  Possible risk can be car accident & theft. So you took car insurance. Premium you paying to car insurance company is hedging. It is not going to prevent accident or theft. But your loss will be covered to some extent as insurance company will pay you back in car gets damaged in accident.

In financial markets, hedging is primarily used to safeguard your investment against possible adverse price movement. But remember Hedging is not free.  Hedging has a cost associated with it. In Hedging you safeguard one investment by making other investment. Hedging is not a profit making technique but it is used to reduce loss.

Generally it is done using financial instrument called derivatives. And most commonly used derivatives are ‘Future’ and ‘Options’

Financial Market Example:

1. Suppose you are holding shares of MNO Company. Your belief is that 1 year down the line share price of MNO will go up. But parallel to this you are expecting that for some time in the beginning (say 1-2 months)share price can fall also. So to safe guard against this short term loss you can buy a put option (give you right to sell MNO shares at a pre-decided price called strike price). If share of stock price falls below strike price you will incur loss but that loss will be offset by profit you going to earn in put option.

2. MNO is a company which produces tomato sauce. Their whole business is dependent on regular supply of tomatoes.  In addition to the regular supply, company is also worried about risk of price of tomatoes going very high in the near future. If price goes very high profit margins will suffer. So to hedge against this risk, company enters into a future contract as per which company will buy tomatoes at a specific price at a set date in the future. With this agreement now company don’t have to worry about risk of price movements and regular supply of tomatoes is also insured