Hedging
What is the hedging?
Hedging is an insurance-type investment that protects you from the risk of financial loss.
Coverage is similar to insurance in that we take insurance coverage to protect ourselves against one or the other loss. For example, if we own property and want to protect it from flooding. As humans it is not up to us to protect it directly from flooding, but in this case we can take out insurance so that if there is any damage to our property due to flooding, we are compensated.
A cover is an investment which has a purpose similar to that of insurance. The goal is to eliminate or reduce the risk by offsetting the potential loss. If we reduce the risk through hedging, we can also reduce the return.
In the case of insurance, we pay a premium and we may not even get any benefit from it if there is no flooding during the term of the policy.
Likewise, it is not free either. We have to pay the price for it, which reduces the overall bonuses we receive.
Normally, a hedge is to take an offsetting position in a related security, which offsets the risk of negative price movements. This can be done through various financial instruments such as futures, futures, options, etc.
Examples of Coverage
Most areas of business and finance can be covered by under coverage.
Take the example of a manufacturing organization that supplies its products to the local market and also takes care of exporting. Suppose its export sales represent 75% of its turnover. The business will have an influx of foreign currency as its main source of income.The value of this foreign currency may continue to fluctuate and could result in gains / losses.
In order to limit this potential loss, the company could consider this possibility through one of the following activities:
Build your own factory in a foreign country so that the goods produced there can be sold easily without fluctuating prices. foreign currency. This is one way to avoid currency risk.
They can also enter into a contract with a bank to sell their foreign currency at a fixed rate by paying commissions / premiums for it.
It concludes a contract with its main customers to pay them in their national currency.
A company can therefore cover a given risk in several ways. The organization can decide which of the available options is the best (given the availability of its resources and its constraints).
How does the blanket work?
Coverage can be made for items that have a fixed value or for items that have a variable value.
let’s understand them in more detail:
A fixed value item is an item that has a fixed value on the books and requires an outflow of a fixed amount of money in the future.
Here are some examples of fixed value assets:
A fixed rate loan is taken out by the company with semi-annual fixed rate payments.
Fixed coupon non-convertible bonds issued by the company with annual interest payment
As is evident in this type of hedging the amount / rate is fixed well in advance, and this may / may not be synchronized with prevailing market rates when payment actually takes place. For this reason, companies also put in place hedges for fixed value items.
Fixed Value Items
Fixed Value Cover
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Let’s say the organization has issued
non-convertible bonds at an annual coupon rate of 8% and the coupons are paid annually. In this case, the organization estimates that the prevailing market interest rate at the time of the next coupon payment (due in one month) will be less than 8% per annum.
Next, the organization decides to enter into a hedging contract with a bank where it will receive 8% per year. interest on the underlying amount of the non-convertible bonds by the bank and, in exchange, pay LIBOR + 0.25% p.a. interest on the underlying amount.
