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What Is Hedging? A Beginner's Guide

Written by in Business on March 16, 2020

Photo by Micheile Henderson on Unsplash

What Is Hedging? A Beginner’s Guide

Hedging is a term that comes up in all areas of life. Though, the most prominent setting is within the world of finance and investments. Whether you’ve got a vague grasp of the concept or if you’re wondering “what is hedging?” this user-friendly guide will give you the information you need for a well-rounded grasp of hedging, its functions, and strategies one may use when doing it.

What Is Hedging: A General Definition

First and foremost, the word itself simply means to protect oneself from loss on some sort of transaction. Some helpful synonyms include: to protect, guard, cushion, or insure. Generally speaking, to hedge is to take all factors and conditions into account and make a move that reduces the possibility for loss. Essentially, it’s when someone tries to reduce risk.

Now when we’re talking about making moves or transactions, typically these are in the form of investments. Technically, we all perform hedging in some form in our everyday lives. Paying insurance is a helpful example of a non-finance or investment hedge.

We purchase travel insurance before going on a trip to gain control in what could be an unpredictable situation. We all hope nothing bad happens when we head off on a trip, but anything from an injury to stolen property can take place and insurance helps you hedge your bets so you incur as little loss as possible in an unfortunate situation.

See? We’re all doing it without even knowing it.

Hedging In The World Of Investment

The concept is a little different when it comes to investments. Hedging is extremely common among investors as it is a key strategy for risk management. There are many ways to go about hedging, but its overall function is to limit risk in one’s investment portfolio. Here’s the thing, while hedging may reduce your risk, it also reduces your potential reward.

To hedge your investments, you would make offsetting investments which have negative correlations. This means that if one goes up, the other goes down, and vice versa. In the travel insurance example, you’re not able to recover the base cost of insurance, even if you have a claim free trip. Leaving the potential reward of not having an accident lessened.

As you’ve likely come to understand, hedging isn’t exactly a huge cash cow, but rather, a way to protect yourself from losses.

If your investment makes money, your hedge will reduce the money you could have made. Though, if your investment loses money, your hedge will work to ensure you don’t take a huge hit.

Other Types Of Hedging

The above examples covered some types of hedging within the securities market. Other areas in which one may hedge are as follows: Interest, weather, commodities, and currencies.

Interest encompasses borrowing and lending rates. Hedging in interest is to protect oneself from rising or falling interest rates.

Hedging weather may sound like a strange concept, but there are situations in which one’s earnings are dependent upon the weather. Farmers, for example, could hedge against the weather to protect from the loss associated with a bad harvest.

Commodities is in reference to tangible items such as precious metals, oil, livestock, wheat, etc. Both consumers and producers can hedge  their commodity price exposure.

As for currency hedging, this is when someone works to mediate risk from currency volatility. One would use this tool with currency to protect against changes in exchange rates. For example, if someone knows they will need a specific currency in the future, they can buy that currency when it’s low and take delivery on a future date. This is not to make gains, but simply to prevent loss at a later date.

Foreign Exchange Hedging 

As mentioned, a facet of this financial tool is currency hedging, also known as foreign exchange hedging. Currencies are known to be volatile, some more than others, and it’s important to protect yourself if you consistently deal with multiple currencies. 

The process works in six steps. First, you must identify exposures. Foreign exchange exposure means the risk a business takes when making transactions in other currencies. Moreover, it refers to identifying the vulnerability of a currency in regards to depreciation. Put simply, identifying exposures is analyzing risk. 

The next step is formulating a currency risk management policy within your organization. You would then determine your budget rates and goals, formulate a hedging strategy, execute said strategy, and analyze your results and adjust accordingly. 

Risk management in the sphere of currency is an strategy-heavy task, particularly if you are working with highly volatile currencies. Though, it can be extremely beneficial when executed mindfully. A key component of the strategy is also a consistent re-analysis of results and re-strategizing as needed. 

There is also the ability to utilize Foreign Currency Options which can be imagined as insurance policies. They give the individual a chance to buy or sell a currency at a specific price on or before a date in the future. 

Simplified Strategies

Most strategies broadly fall under the main two strategies which are forward contracts and spot contracts.

Forward contracts are when two parties sign a contract, agreeing for the buying or selling of assets on a specific date and price. The contract is non-standardized that is agreed upon today for a future transaction. Forwards can be used to hedge risk or allow you to take advantage of a favorable exchange rate prior to the future delivery date. 

Conversely, spot contracts are agreements to buy or sell an asset today, or rather, on the spot. 

Advantage & Disadvantages 

Hedging has clear advantages, being risk minimization and support through hard market periods. As for disadvantages, it typically involves costs that can consume the profit.

It is also a difficult strategy for short-term investors. Hedging can also be frustrating when a market is performing especially well, as investors who hedge have negative correlations on their earnings. Lastly, successful hedging requires strategy, knowledge, and experience.

Some types of hedging, currency hedging, for example, are far easier for beginners to master.

If you’re looking to reduce risk in your business, finances, or investments, hedging might be a useful tool to keep in your toolbox.

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