Hedging: Characteristics and Methods
When investors buy stocks and other financial assets, they are worried about their further value and unfavorable movements in the market value. The easiest way to protect in this case is to set a stop order to close the deal (stop loss). But the stop-loss is not always effective as sometimes prices can be volatile. Experts use hedging strategies to eliminate any negative impact.
Hedging is a risk management tool that allows for the acquisition of one asset to compensate for the possible adverse movement of another.
Instruments of Hedging
First of all, let’s have a look at the hedging instruments:
- Futures are contracts giving a mutual obligation to buy or sell an asset on a specific date in the future at a determined price. They are represented on various groups of assets: indices, stocks, bonds, currency, and commodities.
- Options mean the right to buy or sell some underlying asset for a limited period of time at a specific price. The call option gives its holder the right to buy the underlying asset, and the put option is related to sale.
- Swaps are contracts for which an asset is sold with the obligation to repurchase it at a fixed price. This type of hedging can be used to finance collateral securities.
- Forward contracts are documents that fix the terms of the transaction (the price of goods regardless of changes in market value, exchange rates, etc.).
Methods of Hedging
Types of hedging:
- Classical hedging means that the risks are fully covered by the simultaneous opening of positions in different directions on the underlying and derivative assets. For example, an investor decides to purchase shares for the purpose of their future growth, however there is a big risk that they may decrease in price.
- Full hedging assumes coverage of the whole transaction.
- Partial hedging means that hedging does not occur on the entire sum of the basic asset, but on a certain part of it.
- Selective hedging means compensating risks for a specific asset.
- Cross hedging means the use of securities with similar in price quotations. It means that a trader buys futures of not the basic asset, but a completely different one. This method is based on the trader’s trading strategies and his personal observations. For example, some traders buy gold when oil prices decrease.
- Anticipatory hedging can serve as a tool to hedge currency risks when planning a transaction. When planning further implementation of the transaction and observing the appropriate value of the asset, an investor buys a futures contract on the certain asset, and its current value is fixed for the transaction in the future.