HEDGING METHODS AGAINST RISKS | CCP 2022 EXAM
In this article, you will learn the meaning of hedging methods against risk as per CCP Syllabus 2022 for Exams in 2022.
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In this article, we are going to explain one of the important topics of hedging:
- The meaning of hedging,
- The types of hedging,
- Strategies for hedge
- Advantages of hedging
- Disadvantages of hedging
- And Best Study Material for CCP Exams
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Let’s begin with our topic:
Most of the time, hedges are discussed in more general terms than they are explained. Despite its esoteric nature, it is not a rare term. Hedging can be beneficial to beginning investors & as a prospective Credit manager it becomes much important for CCPs to know the credit risks & the ways to limit them.
Considering hedging as an insurance policy is the best way to understand it. By hedging, people protect themselves from the effects of a negative event on their finances. There are still some negative events that can happen despite this. If, however, a negative event occurs, and you’ve properly hedged, you’ll be less impacted.
There is almost no place where hedging does not occur in practice. As an example, homeowners insurance protects you against theft, fire, and other unforeseen events.
What is the meaning of Hedging?
The concept of hedging in finance refers to the process of protecting investments. Hedging is an investment status that aims to reduce potential losses associated with the money that is invested. Hedging is mostly used by the investors who invest in market instruments. To hedge, technically, means investing in 2 different instruments having an adverse correlation. The best example of insurance is using auto insurance to protect motor vehicles from damage caused by an accident.
Hedging techniques are used not only by individuals but also by asset management companies (AMCs) to mitigate various risks and avoid potential negative impacts. Although, hedging will not prevent the investment from losing, but it will reduce the extent of the negative impact of loss. Hedging is used in the below areas:
Securities Market: This area popularly includes investments in shares, stocks, indices and so forth. The risk associated with investing in the stock market is known as securities risk or equity risk.
Commodities Market: Commodities Market includes metals, energy products, agricultural products and & when money invested in commodities, the risk, simply, is called commodity risk.
Interest Rate: This area have borrowing and lending rates included. The risk associated with interest rates is simply called as interest rate risk. Interest rate risk arises on account of no knowledge about:
- i) how much interest businesses could pay for loans, whether already made or planned, or
- ii) how much interest businesses could earn from deposits, whether already made or planned.
Weather: It may seem interesting, but insurance is also possible in this area.
Currencies: This area includes foreign currencies and various associated risks such as volatility and currency risk.
What are the types of Hedging Strategies?
Hedging strategies are broadly classified as follows:
Futures Contract: This is a standard contract between 2 parties to buy or sell an asset at an agreed price and quantity on a certain date. This includes various contracts such as the currency futures contract.
Money Markets: These are markets where short-term buying, selling, borrowing and lending with maturities of < 1 year takes place. This includes various contracts such as covered calls to buy shares, money market operations for interest and currencies.
How is Hedging done by Investors?
The AMCs generally employ the following hedging strategies to mitigate losses:
Allocation of Assets:
This is done by diversifying the investor’s portfolio with different asset classes. For example, you can invest 35% in the stock market and the rest in stable asset categories. This will break-even your investments.
One of the main tools for allocation is Modern Portfolio Theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measurements to determine the effective frontier for the expected rate of return for a defined level of risk. The theory examines the correlation between different assets & the volatility of assets with the aim to create an optimal portfolio. Many financial institutions use MPT in their risk management practices. Investors will have different risk tolerances and MPT can assist in portfolio selection for a particular investor.
- Structure: This is done by investing a certain portion of the portfolio in debt instruments and the rest in derivatives. Investing in debt ensures portfolio stability, while investing in derivatives protects you from various risks.
- Options: This strategy includes call options and puts options to help make it easier for investors to directly secure their portfolio.
Options are powerful tool & Investors who want to secure individual stocks with adequate liquidity often purchase put options to protect against any downside risk. It increases the value of the profit when the price of the underlying security falls. The main disadvantage of this approach is the premium amount for buying put options. Purchased options are subject to time decay and lose value as they move toward expiration. Vertical put spreads can reduce premium amounts spent, but limit the amount of protection. This strategy only protects individual stocks, and investors with diversified holdings cannot afford to hedge every single position.
Staying in Cash:
It is a “no investment” strategy. Here the investor does not invest in any asset and thus keeps his cash in hand.
What are the Advantages of Hedging?
- Hedging limits losses to a large extent.
- Hedging increases liquidity by making it easier for investors to invest in different asset classes.
- Hedging requires lower margin expenses and thus offers a flexible pricing mechanism.
What are the disadvantages of Hedging?
- Hedging involves costs that tend to eat up the profits.
- Risk and reward are usually proportional to one another; therefore, a reduction in risk will lead to a reduction in profit as well.
- For most short-term traders, such as a day trader, hedging is a complex strategy to follow.
- If the market is doing well or moving sideways, then hedging offers little benefit.
- Options or futures trading, often requires higher amounts or funds such as larger capital or balance.
- Hedging is a precise trading strategy & a successful hedging requires one to have some good trading skills & experience.
What is De-hedging?
De-hedge means to close an existing hedge position. This can be done in cases:
- Where hedging is no longer needed,
- Where the cost of hedging is too high, or
- if one is seeking to take on the additional risk of an unhedged position.
All in all, hedging provides traders and investors with a means of mitigating market risk and volatility including minimizing the risk of loss. Market risk and volatility are an integral part of the market. However, you are not in a position to control or manipulate the markets to protect your investments all their value but hedging can significantly reduce the impact of negative impacts.
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