When it comes to investment, hedging is not a strange word. Though many of you have already heard of the name hedging, not many of you may be able to explain what hedging is. Without the ability to explain the term, I guess you have not yet participated in the hedging world, which actually can be useful to protect yourself. Let us now understand it.
Why there are so many people and well established enterprises use hedging? You need opportunities from investments. But no free lunch, there are risks linked to such investments. To reduce the risks on such investments, many of them choose hedging as one of the methods. There are many different types of hedging products available to cover different types of investments. You can find foreign currency ones, interest rate ones, future ones, options ones and stock price ones.
You have to remember the golden rule that hedging is not a way to help you earn more money. It is a tool to help you reduce the risk. By that, you will invest in two different products that are negatively correlated. The risk is reduced by the offset between the gain and the loss from each of the investment. Or, when investment A is in a gain position, investment is on the contrary a loss position. The gain offsets the loss.
When the risk is higher, the earning or opportunity is likely to be higher, too. But, by hedging, the risk is reduced, therefore, the highest possible earning is also reduced. That means, when you are gaining on investment A, the gain is reduced by the loss in investment B. On the other hand, if you are making loss on investment A, the loss is reduced by gain in investment B.
Let me give you an example on interest rate swap. If you have a loan from the bank of $100,000 and the bank is charging you a floating interest rate (or market rate). You biggest concern must the increase in interest rate (“interest rate risk”), which than you have to pay more interest. To reduce the interest rate risk, you can enter into an interest rate swap with the bank.
When it comes to such hedging instrument, you have a choice to decide if you want to fully hedge or partly hedge. You can enter into a $30,000 hedge or a full hedge of $60,000. Why you want to do so? It is because there is tradeoff between you risks and opportunities. For simple explanation, I assume you have entered into a $60,000 hedge that you receive interest income.
When the market rate goes up, you have to pay more for the loan, but on the other hand, you receive more from the interest rate swap. On the other hand, if the interest rate goes down, you pay less, but you receive less as your interest income. To note that, hedging may not help you eliminate the risk but only reduce, therefore, you cannot expect that the interest pay out should be exactly the same as interest income.
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