Hedging is a risk management strategy adopted by investors to reduce the risk of losses in the market. This is a standard practice that is followed to safeguard the investments in the stock market. In the stock market, this practice helps in restricting the losses that may be affected due to price fluctuations.
Hedging is practised mainly in the following areas where risk is associated.
Commodity: Here, trading is done mainly in agricultural products, energy products, metals, etc. Trading in commodities is mainly done in MCX (Multi Commodity exchange) or NCDEX (National Commodity & Derivatives Exchange Limited). MCX focuses more on precious metals and bullions, while NCDEX focuses more on Agri-based market. The risk involved here is known as commodity risk.
Securities: Risk involved in trading share, equities, indices are known as securities risks.
Currencies: Any kind of risk involved in currency is known as currency risks. There are different types of currency risk like currency risk volatility etc. This kind of trading involves foreign currency.
Interest rates- The risk involved in lending and borrowing rates are known as interest rate risks.
What are the different types of Hedging?
The traders practise three different types of Hedging to gain profits in commodities, securities or interests. The three types of hedging mainly used are:
Forward Contract – This is a non- standardized agreement where two independent parties buy or sell the underlying assets in an agreed date in the future. Forward exchange contracts are made on commodities, currencies etc.
Futures Contract- This is a standardized form of agreement where two independent parties buy and sell the assets on a specified date, at a fixed price. The quantity of the assets is also fixed by the parties.
Money Markets- Here short term borrowing and lending is done, which has a maturity date of one year or lesser. A lot of financial activities are taken care of here, such as money market operations for interests, calls on equity, borrowing selling and lending happen here with a maturity of a year or more.
What are the benefits of Hedging?
- Investors can use hedging technique to lock their profits and survive the market during hard times
- It also reduces the losses to a greater extent
- As investors can invest in several assets classes thereby increase the liquidity
- This saves the time for the long-term trader as they do not have to monitor or adjust the portfolio according to the market volatility
- There is flexibility in the price mechanism because of lower margin outlay
- Successful Hedging helps the traders against price fluctuations in the commodity market or fluctuations in the currency exchange rate, inflation and changes in interest rate
- Hedging also allows traders to practice complex strategies for options trading to maximize their returns
- Hedging also helps in increasing the liquidity in the market
How can investors hedge their funds?
To mitigate the losses various strategies have been opted by the AMCs.
Portfolio diversification– Investors can diversify their investment across various assets classes. Like a part can be invested in equities say 40% while the rest can be invested in relatively stable classes.
Structure– Here, a part of the investment is allocated to debt instruments while the rest is allocated to derivatives.
Investment through options- It includes investment through call and put options, thereby securing the portfolio directly.