Definition of Hedging Transaction
An investor uses a hedging transaction to reduce the risk of losing money or incurring a shortfall when executing their investment strategy.
Knowing Hedging Transactions
Hedging transactions often include derivatives like options or futures contracts, but they can also involve inversely linked assets and take other forms. Typically, they minimize losses in the case of a flawed investing premise but can also lock in a specified profit. Businesses and portfolio managers use them to reduce portfolio risk.
Hedging is generally market-based, whether an investment or a commercial transaction. Investment hedging might involve derivatives like put options, futures, or forward contracts.
These derivatives behave like insurance policies. Derivative buyers pay a premium to hedge. The insurance policy, a tactical hedge, pays out if the strategic investment fails but is a sunk cost otherwise. Sunk expenses are frequently lower than the potential losses investors face if their investment goes wrong; therefore, if it pays off, investors embrace it.
Unlike insurance, hedging transactions provide a third potential that naive investors typically overlook: the investment improves in value, but only a little. When the cost of the hedging transaction is included, the investor may lose a little.
Buying inversely linked assets can help investors hedge against portfolio risks from one asset or another. Investors choose equities with a low correlation with the S&P 500 to hedge against index declines. Hedging trades, more often known as diversification, do not provide direct protection like derivatives.
Global Business Hedging
Hedge trades are vital to the global economy. When a local firm A sells items to a foreign company B, the initial transaction is the sale. Assume firm B’s currency will settle the sale. If company A is concerned about currency fluctuations affecting contract value upon conversion, they can hedge through the foreign exchange market by taking offsetting positions to reduce currency risk.
Hedging trades may not cover the wholesale or asset position. A perfect hedge is technically feasible but seldom used due to high transaction costs. One of two reasons:
Eliminating risk reduces reward. Investors hedge to reduce adverse risk but retain upside rewards.
A perfect hedge may take longer to calculate, monitor, and implement than accepting limiting losses.
Conclusion
- An investor uses a hedging transaction to reduce the risk of losing money while executing their investing strategy.
- To decrease investment risk, hedge transactions use derivatives like options, futures, and forward contracts.
- Inversely linked securities enable more advanced hedging.
