General introduction of hedging

Hedging means buying an asset to reduce the risk of loss from other assets. Hedging in finance is a risk management strategy that deals with reducing and eliminating the risk of uncertainties. This strategy helps to cover losses that may be caused by unknown fluctuations in investment prices.

This mechanism is a standard method used by investors in the stock market to protect their investments against losses. This strategy is also implemented in the following areas:

Commodities: includes agricultural products, energy products, metals and so on. The risk associated with these items is known as commodity risk.

Securities: includes investments in stocks, indices, etc. The risks associated with these items are known as equity risk or securities risk.

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• Currencies: Includes foreign currencies. There are several types of related risks, such as the risk of currency risk fluctuations and so on
• Interest rates: Includes loan rates. The risks associated with these items are known as interest rate risks.
• Climate: It is also one of the topics that can be protected.

We hope you now understand what we mean by hedging. Now let’s look at the benefits and types below.

What do hedge funds do?

In hedge funds, the fund manager collects money from foreign investors and then invests in the same way according to the strategy adopted by the investor. A proportion of the funds are allocated to long-term stocks in which they buy only common stock and never sell on credit. A portion of the fund’s capital is also allocated to the purchase of all privately owned businesses, which the fund often takes ownership of, improves their operations, and then sponsors the company’s initial public offering.

There are hedge funds that deal in bonds or specialize in real estate. Some focus their investment on certain property classes, such as patents and music rights.

Different types of hedging

Hedging is generally divided into three types that help investors make a profit by trading in different commodities, currencies or securities. These three categories are:

• Forward contract: This contract is a non-standard agreement for the purchase or sale of fixed assets at a price set on the date agreed upon by the two independent parties. Forward contracts include various contracts, such as exchange contracts for currencies, commodities, and so on.
• Futures contract: A standard contract for the purchase or sale of fixed assets at a price set on a specific date and a standard amount agreed upon by two independent parties. Futures contracts include various contracts such as commodities, futures contracts, and so on.
• Money markets: One of the main components of financial markets in which short-term loans, borrowing, buying and selling with a maturity of one year or less are made. This includes various forms of currency financial activities, money market operations for interest rates, stock quotes in which short-term loans, borrowing, selling, and loans with maturities of one year or more occur.

The benefits of hedging

•  Can be used to lock profits.
• It enables traders to survive in difficult market times.
• Reduces casualties to a great extent.
• It increases liquidity because it encourages investors to invest in different classes of assets.
• It also helps save time, because with this strategy, long-term traders do not have to monitor and adjust their portfolio with daily market fluctuations.
• Provides a flexible pricing mechanism because it requires less cost than margin.
• Successful hedging protects traders from changes in commodity prices, inflation, exchange rate fluctuations, interest rate fluctuations, and so on.
• Coverage using option trades provides an opportunity for traders to apply sophisticated options to maximize returns using trading strategies.
• Helps increase liquidity in financial markets.

How do investors cover hedge funds?

There are several strategies used by investors to reduce risk, such as:

• Asset allocation is done  by diversifying the investor portfolio with different asset classes. For example, you can invest 40% of your capital in stocks and allocate the rest of your capital to fixed asset classes. This helps balance the investment.
• Structure: It is done by investing a certain part of the portfolio in bonds and the rest in derivatives. Investing in debt creates stability while investing in derivatives is used to hedge risk.
• Use of options:  This option includes purchase options and method options that you can easily secure assets directly.
• Arbitrage strategy:  very simple and at the same time very smart. This strategy involves buying a product and selling it quickly in another market at a higher price. Therefore, in the presence of such an opportunity, a small but constant profit is guaranteed. This strategy is commonly used in the stock market.

Consider a very simple example of a high school student who buys a pair of Asics shoes from an outlet store near his home for only $ 45 and sells them to his schoolmates for $ 70. The second student is also happy to find a much cheaper price compared to the department store that sells the same shoe for $ 110.

• Average reduction strategy:  involves buying more units of a particular product even if the cost or selling price of the product has decreased. Stock investors often use this strategy. If the price of a stock they have already bought falls significantly, they will buy more stock at a lower price. Then, if the price rises to a point between their two purchase prices, the profit from the second purchase may cover the losses of the first case.

The last word

Hedging is an important method that investors can use to protect their investments from sudden and unforeseen changes in financial markets.

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