How Many Types of Hedging Arrangements? ( Example and Explanation)

Hedgers

Hedgers are the traders that want to protect their assets/wealth from the adverse movement of the price in the market. They want to protect their interest and want to avoid the risk of fluctuations.

Any business can be hedged that opts to protect their assets by transferring the risk. The hedging is done by a future contract that helps to avoid the impacts of the price fluctuation on the commodity.

Any type of business including retailer, manufacturer, or producer can opt to hedge if they have risk exposure of the changes in the interest rate, changes in the exchange rate, and changes in the price of goods, etc.

There is a difference between the hedgers and speculators as hedgers manage the risk with the future contract to avoid the loss. On the contrary, the speculators assume the risk to make a profit. So, it’s the difference of the intentions that is to avoid the risk and to presume the risk.

Risk management and hedging

Hedging is one of the well-known techniques to manage risk arising in the normal operations of the business. However, the business has to lose the chance of earnings if they opt for hedging.

However, hedging can be an excellent tool to manage the risk if the business is expecting adverse movement in the prices and expects a hit on the bottom line of the income statement.

Hedging arrangement

Different types of hedging facilities can be arranged by businesses to hedge their exposure to the risk. These arrangments mainly include derivative arrangments and diversification arrangments. Let’s understand these methods of hedging.

Derivative arrangments

Sometimes investors manage the risk of a portfolio by using financial instruments called derivatives. The derivative is a contract between two or more parties and the value of this contract is dependent on the value of the asset under consideration/underlying asset.

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The derivative arrangement may be financial instruments that include contingent claim/forward claim

1) Contingent claim

The contingent claim includes option contract and future contract. The option contract gives an investor the right to buy/sell the securities at a specified price in the future before the date of expiration.

It’s the right of the hedger to exercise the call option (purchase the securities at a pre-determined price) or put option (sell the securities at a pre-determined price).

In the call option, the buyer speculates an increase in the price while the seller speculates a decline in the prices. On the other hand, in the put option, the seller speculates a rise in the price and the buyer speculates a price drop.

The futures contract is a simple contract between the parties to buy and sell the securities in the future at pre-determined prices.

The producers and the buyers can agree on a price and avoid the risk of fluctuations. It’s also based on the speculation where the seller expects the prices to decrease in the future and the buyer expects prices to increase in the future.

2) Forward claims

The forward claim includes swaps and forward contracts. Swaps are the exchange of financial instruments between the parties.

In the swap arrangements, the cash flow or financial liabilities are exchanged between the parties. The most common types of the swaps are interest rate swap and the exchange rate swap.

For instance, In interest rate swaps the financial liability of one party to pay the interest on the variable rates is exchanged with another party that got financial liability to pay the interest on the fixed rate.

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Both the parties hedge their future payments in line with the speculation for fluctuation of the interest rate as no one want to be in an adverse position in the future.

Further, the swaps do not trade on the exchange and these are the contracts between businesses and financial institutions.

Diversification arrangement

The diversification arrangement involves diversifying the investment portfolio by multi-asset trading and hedge to get a sound return.

Although, it’s not a direct hedging technique rather it’s a great risk management approach to ensure controlled exposure of the risk to volatility and market fluctuations.

Example of hedging

Insurance is a prime example of risk management by hedging. In an insurance contract, the holder of the insurance policy makes payment to the insurance company to cover the loss in case of an adverse event/situation.

The negative event/situation does not always happen but an active insurance policy ensures coverage for the risk of adverse event /situation. 

Investors, portfolio managers, and corporations use hedge techniques to protect their investments by acquiring an interest in the opposite related investment, this helps to control the exposure of the risk to the investment.

Advantages of hedging

Following are some of the advantages related to hedging.

  1. Hedging helps to lock the profit for the business. For instance, the business might have achieved profit by normal trading operations and wants to cover the risk for fluctuation of the interest rate.
  2. Hedging limits the losses to a greater extent – (once profit is locked there is no need to acquire further risk).
  3. Investors seeking hedging invests in different types of investments. Hence, the liquidity of the financial market increases.
  4. Successful hedging protects investors from different risks like fluctuations in the prices, interest rate, inflation, and the price of the commodity.
  5. Once hedging formalities are fulfilled, it gives peace of mind to the business owners and they can focus on their core expertise.
  6. The hedger is not required to monitor the investment portfolio again and again. Hence, it helps to save the time of the hedger.
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Disadvantages of hedging

Following are some of the disadvantages related to hedging.

  1. The hedging provides a safeguard against losses but it does not let the organization make a profit from the hedging instrument.
  2. It’s a more risk-averse strategy than a risk management strategy.
  3. Traders dealing with short-term investments may find it difficult to operate the hedging. For instance, for a day trader hedging, maybe a difficult strategy to follow.
  4. If the market is going up it may be actually a loss for the business to hedge.
  5. The hedging turns to be fruitful only if the expectation of the hedger is met and the situation turns to be adverse for the hedger.
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