There are many ways to reduce your investment risks like research and analysis. But if you have a risky investment on hand, research and analysis may not be that helpful, you may need something more practical such as hedging. Hedging is a very powerful tool to reduce risk and is using by many different investors and well established enterprises. Let us begin to understand more about hedging.
As we have mentioned, hedge is a tool to reduce investment risk which is inherent to every investment. You can think in a way that hedge is sort of an insurance for your investment. When the risks you are facing are getting bigger and bigger, you are more in need of hedging. There are many different types of hedging that suits your different type of investments. You can find foreign currency swap, interest rate swap, futures hedging and hedging for stock price as the common ones.
The core objective for hedging is to reduce the risk instead of earns money. Therefore, what you would do is to invest in two products that are negatively correlated. In simpler term, that is when investment A earns money, investment B will lose money. The gain and the loss offset each other that your risk is minimized.
It always makes sense that, the higher the risk, the high the opportunity. When the risk is reduced by hedging, you can expect the highest possible earning to be reduced, too. But on the other hand, as the risk is reduced, when you are losing money, the amount that you are going to lose can be lesser.
To illustrate more clearly, we can now assume a case with interest rate swap. Assume that you have borrowed a $60,000 loan from a bank. No doubt, the bank will charge you interest say at LIBOR + 2%. As an interest payer, you must be concerned that the interest rate may increase. Therefore, you enter into an interest rate swap with the bank to receive a floating interest income at LIBOR + 2%.
When it comes to such hedging instrument, you have a choice to decide if you want to fully hedge or partly hedge. You can enter into a $30,000 hedge or a full hedge of $60,000. Why you want to do so? It is because there is tradeoff between you risks and opportunities. For simple explanation, I assume you have entered into a $60,000 hedge that you receive interest income.
When the LIBOR increases, the bank will charge you higher interest on the $60,000 loan. This higher interest pay out can be offset by the higher interest income from the interest rate swap. Or, if the LIBOR decreases, the bank will charge you less for interest. But, you will also have lesser interest income from the interest rate swap. For this simple case, you may notice that the hedge is perfect as all the risks are totally offset. But in reality, it is seldom the case. You may still have a little bit gain or a little loss.
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