What: Hedging allows a risk-free investor to transfer his risks by paying some cost to a risk taker
Why: Hedging is important because it allows its investments as per his risk apetite
How: Some famous instruments of hedging are futures and options that are traded through stock exchanges
When everything is going your way, it looks natural to get carried away by the upside and completely forget the downsideWhen you are crossing a road, looking to your left is just as important as looking to your right. This rule could be applied even to your investments. But many investors forget this simple rule when they are standing in the middle of markets going up and down. When everything is going your way, it looks natural to get carried away by the upside and completely forget the downside. Then one fine day, you get knocked down by something coming from the other side. For this simple reason, it is always better to keep your investments hedged if you are not sure if you could survive unexpected knocks.
Think of hedging as a kind of insurance that you buy to protect yourself from unforeseen losses.
Hedging could be used in a wide range of circumstances. The techniques of hedging would be as much relevant to your leaking umbrella as to your investments. You keep the second option ready, just in case. Like insurance, hedging involves participation of a risk-taker and someone who is risk-averse. For transferring the risk or what we call hedging, a risk-averse person has to pay a price to a risk-taker.
Hedging keeps a risk-averse person protected from a negative event while someone else assumes the risk in the hope that the negative may not materialize.
The key to hedging is that it allows limiting of loss on the downside. However, at the same time, the cost involved in hedging leads to reduction of upside potential of profit. The risk-taker makes some profit in terms of the price received from the hedger in case the negative event does not actually materialize.
If Hedging is a reduction of risk at the cost of reduction of potential profit, then why anybody would go for hedging?
Hedging is closely connected with the equation of risk-return trade-off. As per the risk-return equation, to generate a higher return you may have to take a higher risk.
A lower risk investment generates a lower return. That’s the normal equation the market follows—it is risk that’s ultimately getting translated into money. Interestingly, all of us have the same appetite for money but all of us may not be having the same appetite for taking risk.
The solution is to go for a compromise. Be satisfied with that much return which is commensurate with your risk-taking appetite. If you never put yourself in a situation offering higher risk than your risk-taking appetite, then you would probably never need to hedge.
But it’s at this point that many slip. The problem is that the equation of risk and return doesn’t come clearly written on the face of your investments. You have to judge for yourself. You may realize only after making an investment that you have entered a wrong lane. Hedging, in a way, provides you a chance to set your investments on the right track, as a result of which you are back to the level of your risk-taking appetite. However, as I said, you have to sacrifice some of the returns on your investments. So, before going for hedging, it is important to make some evaluation based upon its cost and benefit. A long-term investor may decide to ignore any short-term fluctuations rather than sacrifice a part of the profit. It all depends upon individual circumstances.
How can we hedge?
The simplest approach would be to create a natural hedge around your investments. Remember this age-old advice from simpletons: never put all your eggs in the same basket. Diversification works as a natural hedge for your investments. Some of your investments would perform well, some would perform badly but diversification on the whole ensures that you get a balanced return during normal times. But diversification alone can’t always fully protect your investments. A more aggressive approach would be to use derivative instruments for hedging. Many derivative instruments such as options, futures and other derivatives of more exotic kinds are available. Derivatives could be used to hedge a wide range of risks covering stocks and commodities or even currencies and interest rates. For retail investors, derivatives such as futures and options, which are easily tradable on stock exchanges, are most suited. You can hedge your investments by making investments in any of the available derivative instruments. But before that, you should try to understand how different derivative instruments work. I have always found derivatives a bit puzzling. But for avoiding a sea of risks, you need to make friends with a devil.
