What is 'Hedge'

Hedge
Managing risks is one of the primary functions of finance. Risk management as a function is based on reducing the financial risks arising out of adverse price movements. If you have invested in a stock, the fall in stock price is an adverse event, and it can impact your portfolio. Hedging is used to reduce the financial risks arising from adverse price movements.

Hedge meaning
A hedge is an investment to counter or minimize the risk of adverse price movements in an asset or security. Hedging is mainly done through derivative products to take an opposite position in the underlying security or a related security. Simply put, you need to take an opposite position in the underlying security or related security to reduce the risk of adverse price movement. Diversification is also a form of hedging which reduces the risk of adverse price movement in a particular security.

What is a hedge, and how does it works?
Hedging can be considered similar to an insurance policy. If you have an asset in an earthquake-prone zone, you would want to insure that asset against earthquakes. This is done to reduce the risk of an adverse event. Thus, you have effectively hedged your asset against earthquakes in the case of an earthquake, and thus you are protected from an adverse event.

Hedging always has a risk-reward tradeoff. Although hedging reduces the risk of an adverse price movement, hedging is also known to reduce the return on the investment in case of favourable price movement. You have to sacrifice potential gains in the case of hedging. But most people would like to buy an insurance policy and pay monthly premiums to reduce the chances of a large loss. Thus, hedging is based on the philosophy of reducing big losses and sacrificing the gains by a bit.

Money managers reduce the portfolio's exposure by following the hedging techniques and principles. They reduce the risk of adverse price movements and sacrifice some of the gains to achieve that.

Perfect hedge meaning
A perfect hedge is a hedge that eliminates the risk by 100%. A perfect hedge is a theoretical concept; in reality,, the costs will not allow a perfect hedge. Perfect hedging is not done in practical situations; you need to hedge only a part of the portfolio or hedge it for a limited time.

Hedging practical applicability
Hedging is usually achieved through derivative instruments. A derivative instrument has a well-defined relationship to the underlying security. The derivative instrument can be a future, forward, option or swap. The underlying asset can be a bond, stock, commodity, index, etc. The derivative will be structured to reduce the risk of the adverse movement in the underlying investment.

For example, you buy ten shares of Reliance at Rs 10. Also, you buy put options of 10 shares for a strike price of Rs 8. Suppose the premium for the option is Re 1 and the expiry is one year. Now suppose, in the next one year, the price moves to Rs 15. Thus, you gain Rs 4 per share or total of Rs 40. You benefit from the positive movement in the underlying investment and lose on the derivative hedge.a

Suppose, in this example, the price moves to RS 2. You can exercise the put option at Rs 8. Therefore, you lose just Rs 3 per share or a total of Rs 30. This is the maximum loss you will face. If you had not hedged, you might have lost R 8 per share or a total of Rs 80. Thus, the hedge reduces your loss in an adverse price movement.

This is just an example, and if you want to hedge, you can find a derivative contract to hedge your positions. The variables of the hedge help one to estimate the price of the hedge. Usually, the cost of a hedge is related to the chance of the adverse price movement and the loss because of that adverse movement. Therefore, the price of a hedge varies if the risk of an adverse event is higher.

Diversification is a hedge
Suppose you invest in the 5-star hotel stocks, a luxury goods investment. Now, you worry that the luxury segment is facing headwinds. So, you can diversify into defensive stocks like the pharma sector. You will benefit from your investment if the luxury goods sector continues to do well. If it does not perform well, the pharma sector might help you get the returns.

In some cases of diversification, the hedge might not work. The reasons can be:-

• Both the stocks react negatively to an adverse event.
• Both stocks might be affected at the same time because of two completely different reasons. In this case, the hedge of diversification does not work.
• Hedging Risks

There is never a guarantee that the hedge will work. For example, in the diversification case we studied, we learned that the hedge might not work in some cases. Thus, the guarantee of the hedge working or not is an issue. Also, the hedging costs might be very high, and it might not be worth hedging. Finally, hedging as a technique only reduces the chance of losses and can’t get you a higher return.

What is a perfect hedge?
A perfect hedge is a hedge that eliminates the impact of an adverse event. It is more of a theoretical concept and lacks practical use.

What is the risk-reward tradeoff in hedging?
hedging has costs associated, and the risk-reward tradeoff studies the benefits of hedging against the impact of an adverse impact on the underlying. Hedging should be done after all costs and if the benefits outweigh the costs.

How can I use put options as a hedge?
Suppose you own a particular stock. You are worried about an adverse impact in a limited time frame. You can buy put options, an option to sell at a particular price. This particular selling price will act as a hedge, and you can sell the stock at that price at a future date.

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