INTRODUCTION to

HEDGING
By: Angelica B. Marquez
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HEDGING

Offsetting or protecting against the risk of

adverse price movements.

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✘ A hedge is an investment that is made
with the intention of reducing the risk of
adverse price movements in an asset.
Normally, a hedge consists of taking an
offsetting position in a related security.

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 HEDGING
VS.
INSURANCE

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✘ Insurance transfers the finically risk of an
unforeseeable event from the individual to the
insurer.

✘ Hedging is taking precautions to lesson the

impact of a certain foreseeable but not
definitive peril.

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✘ There is a risk-reward trade off inherent in
hedging.
✘  A perfect hedge is one that eliminates all
risk in a position or portfolio. 
✘ Diversifying a portfolio to reduce certain
risks can also be considered a hedge.

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✘ Most investors who hedge use derivatives.
✘ Not only individual investors but portfolio
managers and large corporations also use
this hedging technique to minimize the
exposure to various types of risks and
decrease the negative impact thereon.

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AREAS of HEDGING
and their
RISK
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A business can implement a hedging technique in the
following areas:

✘ COMMODITIES
✘ SECURITIES.
✘ CURRENCIES
✘ INTEREST RATES
✘ WEATHER
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COMMODITIES
✘ Commodities include agricultural
products, energy products, metals, etc.
The risk associated with these
commodities is known as “Commodity
Risk”.

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SECURITIES
✘ Securities include investments in
shares, equities, indices, etc. The risk
associated with these securities is
known as “Equity Risk” or
“Securities Risk”.

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CURRENCIES
✘ Currencies include foreign currencies.
There are various types of risks
associated with it. As an example
“Currency Risk (or Foreign Exchange
(Currency) Exposure Risk)”

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INTEREST RATES
✘ Interest rates include lending and
borrowing rates. The risks
associated with these rates are
known as “Interest Rate Risks”

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WEATHER
✘Weather is also one of the
areas where hedging is
possible.

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Hedging Strategies

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HEDGING STRATEGIES
- A hedging strategy generally
refers to the risk reduction
technique of an investment.

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Through Asset Allocation

You can do this by diversifying your portfolio

with more than one type of asset

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Through Options

You can do this by buying a put option to

protect a portfolio of the cash market.

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Through Structures

You can do this by investing a portion of the

portfolio in debt and the other in derivatives. Where
debt portion brings stability to the portfolio, the
derivatives help in protecting it from the downside
risk.

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Staying in Cash

It is a ‘No Investment’ strategy. Here, the

investor does not make an investment in any asset
and thereby keeps his cash in hand

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Exchange Rate Risk-Hedging
Tools

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 Borrowing or Lending

Forward contract Hybrids

Future Contract Currency swap

Options Interest rate swap

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Borrowing or Lending

Borrowing or lending in different currencies to

take advantage of interest rates differentials and
foreign exchange appreciation/depreciation; can
be either on a certain basis with “up-front” costs or
speculative.

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Impact on risk

Can be used to offset exposures in existing

assets/liabilities and in expected
revenues/expenses.

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Forward contract

“Tailor-made”contracts representing an
obligation to buy and sell, with the amount, rate,
and maturity agreed upon between the two
parties;has little up-front cost.

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Impact on risk

Can eliminate downside risk but locks out

any upside potential.

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Future Contract

Standardized contracts offered on organized

exchanges; same basic tool as a forward contract
but less flexible because of standardization; more
flexibility because of secondary-market access; has
some up-front cost.

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Impact on risk

Can eliminate downside risk, plus position

can be nullified, creating possible upside
potential.

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Options

Tailor-made or standardized contracts

providing the right to buy or sell an amount of the
currency, at a particular price, during a specified
time periods; has up-front cost(premium).

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Impact on risk

Can eliminate downside risk and retain

unlimited upside potential.

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Interest rate swap

Allows the trading of one interest rate

stream for another; fee to be paid to the
intermediary.

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Impact on risk

Permits firms to change the interest rate

structure of their assets/liabilities and achieves
cost savings via broader market access.

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Currency swap

Two parties exchange principal amounts of two

different currencies initially ; they pay each other ‘s
interst payments and then reverse principal amounts at
a preagreed exchange rate at maturity; more complex
than IRS.

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Impact on risk

Has all the features of interest rate swaps,

plus allows firms to change the currency structure
of their assets/liabilities.

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Hybrids

A variety of combination of some of the

preceding tools; may be quite costly and/or
speculative.

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Impact on risk

Can create, with the right combination, a

perfect hedge against certain exchange rate
exposures.

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 Sources:

https://www.investopedia.com/terms/h/hedge.asp
https://www.investopedia.com/articles/optioninvestor/0
7/hedging-intro.asp

https://efinancemanagement.com/derivatives/hedging

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