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Hedging is an increasingly popular terms in the investment markets. Though not many people actually enter into hedging, most of them have already heard of the term. In fact, to protect yourself, you should at least have the very basic knowledge of hedging. Therefore, let us now know more about hedging and a way to better protect you from risks.
Why there are so many people and well established enterprises use hedging? You need opportunities from investments. But no free lunch, there are risks linked to such investments. To reduce the risks on such investments, many of them choose hedging as one of the methods. There are many different types of hedging products available to cover different types of investments. You can find foreign currency ones, interest rate ones, future ones, options ones and stock price ones.
The core objective for hedging is to reduce the risk instead of earns money. Therefore, what you would do is to invest in two products that are negatively correlated. In simpler term, that is when investment A earns money, investment B will lose money. The gain and the loss offset each other that your risk is minimized.
As you see from the case of investment A and B, you will know that the risk of losing money from investment B is hedged by the gain in investment A. On the other hand, you can think that the gain in investment A is unluckily reduced by the loss in investment B. It is true that the possible earning from the total investment portfolio can be lower is the risk is hedged. It makes sense as the lower the risk, the lower should be the opportunity and earning.
Let us illustrate more clearly with an example on interest rate swap. Assume that you have a loan from the bank of $50,000. You have to pay interest at the market rate for the loan. There is an interest rate risk that the interest rate goes up and you have to pay more interest. Therefore, you want to reduce your exposure to this interest rate risk and entered into an interest rate swap with the bank.
When it comes to such hedging instrument, you have a choice to decide if you want to fully hedge or partly hedge. You can enter into a $30,000 hedge or a full hedge of $60,000. Why you want to do so? It is because there is tradeoff between you risks and opportunities. For simple explanation, I assume you have entered into a $60,000 hedge that you receive interest income.
When the market rate goes up, you have to pay more for the loan, but on the other hand, you receive more from the interest rate swap. On the other hand, if the interest rate goes down, you pay less, but you receive less as your interest income. To note that, hedging may not help you eliminate the risk but only reduce, therefore, you cannot expect that the interest pay out should be exactly the same as interest income.
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