What is hedging and what are the different types of hedging?

What is hedging and what are the different types of hedging?

Hedging is a common practice used in the finance industry in order to mitigate risks related to the volatility in the price of investments. Hedging helps in retaining the profits or at least reduce losses partially. The managers face lots of uncertainties and contingencies during the course of business be it related to currency exchange or investment opportunities. Hedging plays a critical role in eliminating these contingencies by way of making alternative investments with the mindset that the alternative investments move in the opposite direction of the primary investment.

Hedging can be done in various areas such as commodities (rice, wheat, metals, crude oil), securities (equities, indices), currencies (dollar, euro, rupee), interest rates (both lending and borrowing) and even weather (forecast whether rain or not). The risks associated with these are commodity risk, securities risk, currency risk, interest rate risks, and weather risk respectively. 

Broadly there are 3 types of hedging:

  • Forwards: They are non-standardized contracts between two independent parties to buy or sell an underlying asset at an agreed upon price and at a specified date in the future. For example forward exchange contracts for currencies, commodities, etc. The settlement of a forward contract can be done on a cash or delivery basis. They are over the counter instruments and carry a high risk of default.
  • Futures: They are standardized contracts between two independent parties to buy or sell an underlying asset at an agreed upon price, standardized quantity and at a specified date in the future. For example Currency Futures contracts, Commodity future contracts, etc. They have standardized terms in the contract and are traded on a futures exchange. Due to being traded on an exchange, the risk of default is less as compared to forwards.
  • Money Markets: Money market has become a very crucial component in the finance industry with short term lending and borrowing becoming so frequent. The money market involves transactions that are completed within one year. For example Money market operations for interest, Money market operations for currencies, etc. These are mainly helpful for domestic companies that trade with foreign companies as the domestic companies can lock in the value of its partner's currency. This in return makes the cost of future transactions consistent and make the domestic company capable of paying for the trade at an exchange rate it is willing to pay.
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Coming up Next: What is the superannuation scheme and how much can an employee withdraw from the same? 

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