Jan 23

Importance of Hedging

The financial market has numerous investment instruments and all of them come with their potential of profits and exposure to risk. One of the instruments are classified as derivatives. Derivatives are those instruments that derive their values from an underlying asset. Based upon the underlying, they could be called as equity derivatives, index derivatives, currency derivatives, commodities derivatives, etc. Derivatives not only helps in price discovery but also helps in transferring the risk. The risks could be Diversifiable or systematic and Non – Diversifiable or unsystematic and to minimize this risk fund managers, investors, businesses, banks, etc. uses hedging as a tool.

Hedging is a strategy that immunizes the risk of any potential losses against any negative price movement by transferring it to someone who is willing to accept it. People who take this risk are known as speculators. Speculators create a naked position and expect the market to move in their direction, hence, benefiting them. Their profits and losses are extreme, as they do not protect their position against diversity movement of the prices.

Hedging techniques generally involve the use of a bit of complex strategies using derivatives, commonly futures and options and in some cases hybrid instruments as well. Basically, it is done by creating either a counter position in derivatives or in equity with negative correlation. In this way, the profit of one instrument is offset by the loss of the other, limiting the profits and hence, minimizing the losses.

Hedging primarily uses Futures for security against any diversity in prices. Generally, future is a pre-defined contract whose price is determined by adjusting freight, handling, storage and quality costs, along with the impact of supply and demand factors to the spot price. There is regular change in the prices of spot and futures which is known as the basis, however, the risk arising out of the difference is defined as basis risk and the difference between spot and futures prices is defined as narrowing of the basis.

When the market is characterized by contango, narrowing of basis benefits the short hedger and a widening of the basis benefits the long hedger, whereas, in a market characterized by backwardation, a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger. However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.

We can understand Hedging by an example: An investor buys 1500 shares of XYZ company at Rs. 309 for a total of Rs. 4,63,575, with a view of rise in share prices over the next few months. But there is a fear of fall in share prices due to various circumstances. As his fears, the market falls and he would incur loss so to avoid this diversity against the price movement, he can hedge this position by selling Nifty Future.

First, he needs to consider the risk associated with the shares in respect to the Index, this is known as Beta. Beta is calculated by dividing the difference in rate of return of the share minus the risk free trade by the Index rate of return minus the risk free trade. Now supposingly, the Future of Nifty is trading at Rs. 5778 and the beta of the share is calculated to 0.81, to hedge the position he needs to sell Rs. 3,73,645 worth of Nifty Future i.e. approximately 64 units. Since, Nifty Index contains 50 units in 1 lot, he can either sell 1 lot of Nifty Future or 2 .If he over-hedges and sells 2 lots and the market falls 10%, then notionally, he is at a profit of Rs. 577.8 per lot and loss of Rs. 24.90 per share but an overall profit of Rs. 20,420. In this way the investor not only saved himself from a total loss of Rs. 37,364 instead earned Rs. 20,420 as his expectations.

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