Investment word of the day: Hedging—what is it and how does it work? Types, pros and cons explained

Investment word of the day: While profitability is the primary focus for both investors and businesses, risk management is an equally important factor. Hence, in this dynamic financial world, hedging gains prominence.

Here's all you need to know about hedging.

What is hedging?

Hedging is a strategy used by investors and businesses to safeguard against potential losses of one investment by expecting gains in another. It protects against frequent fluctuations in the price of stocks, bonds, and other securities. Through hedging, investors can minimise risks without selling current holdings. Notably, hedging does not avoid losses, but it helps minimise the impact of such losses.

For instance, an investor may maintain a portfolio through balanced allocation in equity and debt instruments. If the equity market fluctuates, some of these funds can be allocated to debt instruments. In a similar way, if the equity market performs well, the investor can increase the allocation of such funds.

Types of hedging

Hedging can be broadly classified into three types –

• Money market - This involves lending, borrowing, purchasing, and selling instruments with a maturity of one year or less.
• Forward contract - It is an agreement to buy or sell an underlying asset at a specific price on a predetermined date.
• Futures contract: This is an agreement in which an underlying asset is bought or sold at a predetermined price on a specific date.

Why do investors opt for hedging?

• Protection against price fluctuations: Hedging becomes important to safeguard against market volatility, especially for securities prone to price fluctuations.
• Improves liquidity: Hedging helps to maintain liquidity by reducing the risk of losses that would need significant cash or sale of assets.
• Stability of portfolio: If done correctly, hedging helps to reduce the portfolio's volatility due to market turbulence and unexpected downturns.

Pitfalls of hedging

• Complex: Hedging is often considered a complex process that requires a thorough understanding of the financial markets. Hence, it may be a challenging process for new investors.
• Uncertainty: Like most investment strategies, hedging does not guarantee protection from losses. If the market conditions fluctuate suddenly, hedging may not provide protection as expected.
• Expensive: Hedging may become expensive for investors as it includes costs from various sources such as transaction fees, option premiums, and potential losses from the hedge if the market does not perform as expected.

Disclaimer: This article is for informational purposes only and does not constitute financial advice; please consult a qualified financial advisor before making any financial decisions.