ALL ABOUT HEDGING
Hedging can be taken as an insurance like investment alternative which protects investors from risks of any potential losses of their finances.
This is identical to the concept of insurance as we take insurance to cover and protect ourselves from one or the other loss. For instance, if we have an asset and we would like to protect it from floods. As human beings, it is not in our hands to protect it from floods. And as humans it is not in our control to directly protect it from the calamity, but in this case, we can take a cover in the form of insurance so that if there is any damage to our property on accounts of floods we get compensated for the same.
- Hedging is an investment that has a similar role as that of insurance. The purpose is to vanish or reduce the risk by offsetting the potential loss. If we are reducing the risk through hedging, then we might reduce the reward also. In the case of insurance, we pay a premium amount and might not even get any type of benefit from that if there is no calamity during the policy tenure
- Identically, it is not free either. We have to pay a cost for it which in turn reduces the overall rewards which we are going to get.
- Usually, a hedge consists of taking an offsetting position in a related security which offset the risk of any drastic or adverse price movements. It can be done through various instruments such as F&O, forward contracts among others.
EXAMPLES OF HEDGING
Most of the aspects under the scope of finance and business can be covered under hedging. Let us take an instance of a manufacturing entity that supplies its product in the local market and is also exporting the same.
Let’s assume that export forms 75% of its revenue. The entity will have an inflow of forex as a primary source of income and revenue. The value of this forex keeps fluctuating and can lead to losses or gains.
In order to restrict the potential loss, the company might counter this through either of the following:
- Enter into a contract with the key and major customers to pay them in their domestic currency.
- They can also sign a contract with a bank to sell their forex at a predefined rate by paying the premiums or fee for the same.
- Build its own factor in that foreign country so that the manufacturing can easily be sold without any forex fluctuations.
So an entity can hedge a given risk in many ways. The entity can decide which of the options available with them can be the ideal and apt for them.
WORKING OF HEDGING
This can be done for items that have a variable value or for items that have a fixed value. Let us understand both of these scenarios.
1. Fixed value items hedging:
A fixed value item is one that has a fixed value in the books and requires an outflow of a fixed amount of cash in the future.
Some of the instances are:
- Fixed coupon NCDs (Non Convertible Debentures) issued by the company with annual interest payouts.
- A fixed interest loan is taken by the company with semi annual fixed interest payments.
It is evident that with this hedge, the rate/amount is fixed very much in advance and this may or may not be in sync with the current market rates when the payment actually takes place. This is the rationale why the companies enter into hedging even for fixed value items.
2. Variable value items hedging:
Contrary to the fixed value items, variable items have fluctuating cash flow at the time of payment. For instance:
- Forex transactions
- Variable interest loans
- Variable NCDs