What is Hedging?
When it comes to investment, hedging is not a strange word. Though many of you have already heard of the name hedging, not many of you may be able to explain what hedging is. Without the ability to explain the term, I guess you have not yet participated in the hedging world, which actually can be useful to protect yourself. Let us now understand it.
Why do you need a hedge? It is because every investment is linked to certain level of risk, a hedge is your insurance that helps you reduce the risks. The higher the risk, the more likely the investors or the companies will enter into hedging. Different types of hedging are available and the common ones are foreign currency swap, interest rate swap, futures hedging and hedging for stock price.
The core objective for hedging is to reduce the risk instead of earns money. Therefore, what you would do is to invest in two products that are negatively correlated. In simpler term, that is when investment A earns money, investment B will lose money. The gain and the loss offset each other that your risk is minimized.
When the risk is higher, the earning or opportunity is likely to be higher, too. But, by hedging, the risk is reduced, therefore, the highest possible earning is also reduced. That means, when you are gaining on investment A, the gain is reduced by the loss in investment B. On the other hand, if you are making loss on investment A, the loss is reduced by gain in investment B.
Let us illustrate more clearly with an example on interest rate swap. Assume that you have a loan from the bank of $50,000. You have to pay interest at the market rate for the loan. There is an interest rate risk that the interest rate goes up and you have to pay more interest. Therefore, you want to reduce your exposure to this interest rate risk and entered into an interest rate swap with the bank.
As mentioned, the hedge reduces your risk and at the same time reduces your possible earning. Depending on how much risk that you wish to reduce, you can enter into swap that amounts to exactly $100,000 or you can just enter one that is $50,000. Let us now assume you have entered into a $100,000 interest rate swap that you receive floating interest income.
When the interest rate increases, you have to pay more interest for your loan, but you receive more interest income on the other hand. If interest rate decreases, you can pay less interest for your loan, but your interest income also decreases. For explanation, hedging can be simple. But in real case, you may not find the hedging is such a perfect hedge that all your risks can be completely eliminated.
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