Hedge (Investment) - Explained

What is Hedging and Investment?

Updated at March 29th, 2023

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What is a Hedge?

A hedge means using a financial transaction to protect yourself against a risk from one of your investments (in this case, currency risk from the contract).

What is a Hedge in Exchange Rates?

Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. However, if the value of the euro in dollars declines, then you are protected by the hedge. When parties wish to enter financial contracts like hedging, they normally rely on a financial institution or brokerage company to handle the hedging. These companies either take a fee or create a spread in the exchange rate in order to earn money through the service they provide.

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What is a Hedge Investment?

A hedge is a type of investment that involves an investor taking loss-limiting trading decisions to counter volatility in an assets value. A hedge is usually applied in a futures or options market and is intended to move in a direction opposite to that of the underling asset.

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How Does Hedging Ones Investment Risk Work?

Hedging is typically an anticipatory action that seeks to address the possible risks involved with making an investment decision. It is akin to an insurance that protects the investor from any eventual volatility of the asset. However, while it significantly reduces risks, hedging also potentially limits gains. In the non-event of a typical loss scenario, hedging might come across as an expensive or even unnecessary preventive action; however the same underlying philosophy is also applicable to insurance better safe than sorry. Experienced investors partake in hedges that promise comprehensive and faultless protection against volatility. However, even a hedge that seems perfect on paper might not always be capable of eliminating volatility in totality. Also, in sharp contrast to its intended purpose, a hedge may sometimes move in the same direction as the asset, thereby increasing basis risk. Moreover, let us face it hedges are expensive.

Hedging By Way of Derivatives

Derivatives are an effective means of hedging. This type of securities not only has a market movement synchronous with that of the underlying assets but also has a well-defined relationship with them. Derivatives come in the form of futures, options, insurance, swaps and exchange traded funds and are used to effectively hedge not only stocks and bonds, but also commodities (such as precious metals), energy, currencies, and interest rates. The "Hedge Ratio", designated by the unit Delta measures the efficiency of a derivative hedge. In the simplest terms, it takes into account how much the derivative moves in price for every dollar that the price of the underlying asset changes.

Hedging By Way of Diversification

Hedging through derivatives is not only an expensive and complicated process but its success also depends on how accurate the risk calculations are. Luckily, there exists a much simpler, (albeit primitive) and cost-effective method of hedging in the form of diversification of portfolios. To a shrewd investor, it is of utmost importance to maintain a diversified portfolio so that losses incurred in certain stocks or utilities can be offset by gains made in others. Diversification is a well-rounded strategy, no doubt, but the market is still at the mercy of unforeseen and potentially catastrophic natural events such as floods and earthquakes or even man-made events such as employee strikes.

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