Hedging

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge.

Process of protecting oneself against unfavorable changes in prices. Thus one may enter into an offsetting purchase or sale agreement for the express purpose of balancing out any unfavorable changes in an already consummated agreement due to price fluctuations. Hedge transactions are commonly used to protect positions in:(1) Foreign currency (2) Commodities, and (3) Securities.

In other words hedging is Hedging is the process of entering into two simultaneous contracts of opposite nature withcorresponding terms, one in the spotor cash market, and the other in the futures market, to offset the loss in one contract by profit in the other contract.

Advantages of Hedging:1. Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors. 2. Hedging tools can also be used for locking the profit. 3. Hedging enables traders to survive hard market periods. 4. Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc. 5. Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility. 6. Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.

Disadvantages of Hedging:1. Hedging involves cost that can eat up the profit. 2. Risk and reward are often proportional to one other; thus reducing risk means reducing profits. 3. For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow. 4. If the market is performing well or moving sidewise, then hedging offer little benefits. 5. Trading of options or futures often demand higher account requirements like more capital or balance. 6. Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

Steps in Hedging:1. Identify the Risks: - Before management can begin to make any decisions about hedging, it must first identify all of the risks to which the corporation is exposed. These risks will generally fall into two categories: operating risk and financial risk. In general, operating risks cannot be hedged because they are not traded. The second type of risk, financial risk, is the risk a corporation faces due to its exposure to market factors such as interest rates, foreign exchange rates and commodity and stock prices. Financial risks, for the most part, can be hedged due to the existence of large, efficient markets through which these risks can be transferred. In determining which risks to hedge, the risk manager needs to distinguish between the risks the company is paid to take and the ones it is not.Another critical factor to consider when determining which risks to hedge is the materiality of the potential loss that might occur if the exposure is not hedged.

2. Distinguish between hedging and speculating: - One reason corporate risk managers are sometimes reluctant to hedge is because they associate the use of hedging tools with speculation. They believe hedging with derivatives introduces additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks.

3. Evaluate the costs of hedging in light of the costs of not hedging: - The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company stands to suffer if market factors, such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative to the potential loss.

4. Use the right measuring stick to evaluate hedge performance: - The key to properly evaluate the performance of all derivative transactions, including hedges, lies in establishing appropriate goals at the onset. Many derivative transactions are substitutes for traditional transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond. Regardless of market conditions, the swap's cash flows will mirror the bonds. Thus, any money lost on the swap would have been lost if the corporation had issued a bond instead. Only if the swap's performance is evaluated in light of management's original objective (i.e., to duplicate the cash flows of the bond) will it become clear whether or not the swap was successful.

5. Don't base your hedge program on your market view: - Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices.

6. Understand your hedging tools: - A final factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options, which comprise the following basic building blocks: Forwards - Swaps - Futures - FRAs - Locks Options - Caps - Floors - Puts - Calls

The manager who understands these will be able to understand more complex structures which are simply combinations of the two basic instruments.

7. Establish a system of controls: - A hedging program requires a system of internal policies, procedures and controls to ensure that it is used properly. The system, often documented in a hedging policy, establishes, among other things, the names of the managers who are authorized to enter into hedges; the managers who must approve trades; and the managers who must receive trade confirmations. The hedging policy may also define the purposes for which hedges can and cannot be used. For example, it might state that the corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes. It may also set limits on the notional value of hedges that may be outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the company's boards of directors are aware of the hedging activities used by the corporation's risk managers and that all risks are properly accounted for and managed.

Hedging strategies:1. Dedicated Short Bias: -This strategy happens when the fund continuously shorts stocks it doesnt own with the expectancy of a decline in value. The fund should perform contrary to the stock market with tremendous results and with funds having high returns when the market goes down and vice versa.

2. Fixed Income Arbitrage: -This strategy uses bonds in a variety of different ways. One example includes the shorting of bonds of higher credit companies. The proceeds are then used to buy bonds of lower credit companies. The idea is that the Bond Confidence Index will move toward 100 and the lower quality bonds will outperform the higher quality bonds.

3. Market Timing: -This strategy is typically based on technical factors (technical analysis) such as price, volume and market sentiment and it are short-term in nature. The goal of this strategy is to buy a financial asset with the expectation that the asset will increase in value.

4. Aggressive Growth: - This strategy deals with investing in stocks that have a high potential for growth due to strong earnings growth or sales. Investors must understand the concept of Standardized Unexpected Earnings (SUE) in order to practice this from of hedge fund investing. This form of investing deals with the buying and selling of stocks in companies that have reported earnings either above or below estimates made by analysts.

5. Opportunistic: - This strategy is a tricky one and depends on the judgment of a portfolio manager. Basically, a fund manager rotates among all possible strategies with it depending on the point of view associated with a particular investment strategy at a specific point in time.

There are many additional strategies for hedging that are available to investors. Strategies such as the managed futures strategy, the sector specific strategy, the market neutral strategy, and the emerging markets strategy should all be considered.