Hedging is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment. The market supply-and-demand dynamics creates unprecedented volatility in the asset prices, thus exposing investors to the downside risk. In an attempt to manage this volatility many investors use hedging as a strategy. Portfolio managers, investors and corporations use hedging strategies to limit risk and curtail potential losses, but with reduced risk comes reduced returns. In designing hedging strategies, investors can choose from a variety of tools, including stocks, exchange-traded funds, insurance and various derivative products.
Employing an effective hedging strategy does not mean eliminating the risk completely, but rather it tries to differentiate acceptable and unacceptable risks and transform the risk that is unacceptable. However, determining the risk that the company is willing to bear and one that needs to be transformed is a challenge in itself. Main purpose of a hedging strategy should be to achieve an optimal risk profile for the company that ultimately creates a balance between the benefits and costs of hedging.
COMMON HEDGING TECHNIQUES
Hedging using Futures
One of the most common hedging techniques involves, buying future contracts. For example – If a company uses crude oil as a raw material, buying future contract for crude oil will lock in the prices at a given date. Hence the company can hedge the risk of potential price rise in future. However, if the prices of crude oil rather falls, the company will still have to purchase crude oil at the agreed price.
Hedging using Options
Options are one of the most popular financial instruments used for hedging because of the versatile returns offered by them. Protective puts and married puts are ideal examples of hedging using options. Married put involves buying shares of a company along with buying a put option with a strike price that is lower than the market price currently. Hence, in case the price goes up investor benefits from the upside potential however if the price goes down the loss is gets offset through exercising the put option thus hedging the potential downside risk.
PROTECTIVE PUT AS A HEDGING STRATEGY – AN EXAMPLE
Protective Put just like married puts are used to hedge the potential risk. For example an investor initially purchases 500 shares of stock A for $30 per share. It would cost him 500*$30 = $ 15,000 (excluding commissions). The stock price rises to $50 after four months thus leading to a profit of $10,000. Selling the share at $50 would prevent the investor from participating in the future profits in case the price rises further. Hence, instead of selling the stocks at $50 the investor can buy a put option with a strike price of $50 and a premium of $4. This is called a protective put. Buying a Protective Put protects the unrealized profits along with hedging the downside risk. Now the investor has locked in a profit and has a right to sell the stock at $50. Below is the profit matrix explain the scenario.
The investor can realize the profits if the price goes up and can exit through exercising the put option in case the price goes down. Hence, he has essentially hedged against the loss, at the same time keeping the upside potential.
COST OF HEDGING TECHNIQUES
All hedging strategies involve an associated cost. Many investors or corporations underestimate the true cost of hedging, by focusing only on the direct transactional cost of buying/selling the securities. However, the true cost of hedging techniques also involves some indirect components that can make hedging expensive for the investors. As a result, cost of many hedging strategies far exceeds their benefits. These indirect costs involves: the opportunity cost of holding margin capital and lost upside. While entering into financial-hedging, a corporation often must hold additional capital on its balance sheet against potential future obligations. This requirement ties up significant capital that might have been better applied to other projects, creating an opportunity cost that managers often overlook. For example, while hedging the annual production output of natural-gas valued at $4 billion through sales, the producer would be required to hold a margin capital to incorporate the potential fluctuations in the gas prices of about 30 to 35 percent in a year, hence creating an opportunity cost. Secondly, the returns lost upside can post a cost on the investors. For example after selling short, the asset prices goes up significantly, the cost of forgoing upside could exceed benefit of downside protection. Thus, cost of hedging can sometimes make the investors and risk mangers reluctant to hedge.
To conclude, though hedging reduces the risk associated with an investment at the same time it involves certain costs. Hence it is important that the managers or investor evaluate the cost and benefit diligently before employing the hedging strategy and only hedge the exposure that poses a material risk on the investment.