How does hedging work and what are its benefits?
You are investing in one asset and securing the risk in this asset by investing in a second asset. The loss you may incur with the first asset is offset by the profit in the second asset. In this way, you are getting two benefits through hedging as it gives you income through these profits along with reducing the risk.
Where can you implement hedging?
Hedging can be implemented in any underlying asset being traded in the market. You can hedge with currencies, commodities like industrial and agricultural products, securities like shares, equity, mutual funds, interest rates and even weather.
What kind of risks are secured by hedging?
Hedging addresses several risks laying in the trading market, the most important being Industry Risk, Equity Risk, Securities Risk, Foreign Exchange Exposure Risk, Volatility Risk, Industry Risk, Interest Rate Risk, Downside Risk etc.
What are the different types of hedging?
Based on the benefit from hedging, the following are some examples of hedging:
- Forward Contract
- Futures Contract
- Money market
- Covered Calls
- Short Straddles
What is a Forward Contract?
It is a non-standardized contract between two parties to sell or buy an asset such as currencies, commodities, etc based on a mutual agreement on the price and date of exchange.
What is a Futures contract?
This is also a contract between two independent sides to buy or sell an asset at a fixed price and date but is a standardized one.
How can hedging help you in the money market?
Numerous contracts, transactions, and exchanges on currencies and money take place in the market and most of them are for short-terms. Hedging gives you security from risks associated with equity, interest rate, mutual funds, bonds etc.
What is a hedging strategy?
Hedging is basically a reduction of risk and the strategy involved is a kind of risk reduction technique, wherein you use flexible techniques to bring down the risk associated with an asset. There is no fixed strategy and it completely depends on the nature of the asset and your decision.
How can you hedge with asset allocation?
You can invest in multiple assets of same or different types so that the risk and profit become balanced from both ends. For example, you can invest 75% in currency and the remaining 25% in another asset with lower or higher stability.
What are other forms of hedging strategies?
You can use Hedging through Structures for reducing downside risk, through options for equity risk, staying in cash strategy for a no-investment trading.