Hedging is an investment that serves to reduce or eliminate the risk associated with another investment. It’s designed to minimize exposure to unwanted business risk, but also allows you to profit from this investment.
Hedging – a strategy for reducing possible losses
To make it easier to understand Hedging, it’s best to see it as a risk insurance that arises from the business. When a company decides to hedge, they insure themselves against negative events. It does not prevent the negative event from occurring, but if it happens and you are properly insured, the impact of the negative event will be reduced and even completely negligible. For example, if you buy a home insurance, you have hedged yourself from fire, burglary or other unfortunate incidents. In the financial market, hedging can be more complex than the simple payment of premiums to the insurance company each year. Investment risk Hedging means the strategic use of instruments on the market to reduce the risk of price changes. It means that investors hedge one investment by investing in another investment. Technically speaking, in order to hedge you must invest in securities with a negative correlation in regard to your true state.
What types of business risks can be hedged?
Usually, they are:
- Risk of exchange rate changes
- Risk of changing the price of goods
- Risk of interest rate changes
- Risk of change in share value
- Credit risk
Since undeveloped countries are in transition, becoming more and more open to the international market, it is also impossible for business entities there to remain isolated for international events. All this requires more modern financial instruments while doing business, there is a growing need for risk reduction due to the unpredictability of the market and large price fluctuations. Reduction of these types of business risks is Hedging.
It is no longer necessary to ask if Hedging is needed but to apply it in practice
All hedging techniques involve the use of complex financial instruments known as financial derivatives. These are instruments, the price of which is derived from a relationship with the main instrument, or their value is derived from the value of another stock paper which is on its basis. In contrast to basic stocks, financial derivatives do not reflect any credit or equity relationship, they represent a type of right to other forms of financial assets. The most famous financial derivatives are forwards, futures, options, and swaps.