I am a heart patient. Just a few days ago I had an attack that landed me in a hospital. But, I am not the prodigal being born with a golden spoon to easily bear the hospital expenses. However, I have medical insurance, which makes the insurance company responsible for the medical expenses. Herein, I have hedged my health risk by getting insured. Hedging is a very important terminology that you will learn in Derivatives.
Hedging in brief:
Every one of us, knowingly or unknowingly is engaged in hedging in our daily life routine. A very simple example that comes to mind when thinking about hedging is that of insurance.
When buying insurance for your car, you typically hedge yourself against a negative event, which might damage your newly bought car. Suppose, unfortunately an accident occurs, or your car gets stolen, you need not worry much, because you had already bought insurance for your car by paying an annual premium. In such an event, the insurance company will take care of the losses and compensate you adequately. Similarly, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. So, Insurance is an example of a real world hedge.
In other words, hedging will not prevent a negative event from occurring, but if it does happen by any chance, and you are properly hedged, the risks of losses accruing to you are minimized.
Now that you have understood what hedging means, you might as well be interested to know more about hedging in financial markets. Some of the questions lingering over your mind may be:
- How do we hedge ourselves against a stock price decline?
- What are the costs associated with Hedging?
- Are there any downside risks we are exposed to while hedging in markets?
We will take a look at all these concerns briefly below:
Hedging By Options/Futures
In financial markets, the instruments typically available with us for hedging are options and futures which had already been discussed in previous readings.
By using Options as a hedging instrument, we can prevent downside losses, while still gaining form the upside potential of the asset. For example – if you want to buy a stock XYZ at $10 after 2 months but fear that its price might go up by about 50% based upon its previous performance. You can simply buy a call option on XYZ stock today by paying an option premium of $1 to the seller, effectively locking the price of the stock at $10. You can buy the stock after 2 months at $10 even if the current market price has increased to $15 (increase by 50%). However, if the price goes down after two months as against our expectations, then you have the option of not exercising the contract and let it expire.
Hence, from above it is clear how we have used call option contract to hedge (protect) ourselves from an increase in stock XYZ’s price in near future. The point to be noted is that this hedging has been done at just a cost of $1 i.e. the call option premium. At the most you can lose is $1 even if the price of XYZ goes down. So, here though you are not totally immune from losses on XYZ, the magnitude of losses has been greatly reduced.
Similarly, futures can be used for hedging. Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.