What is Hedging?

Many derivatives transactions take place on the bourses. Derivatives products like options were designed to act as hedging instruments. Many people misunderstand the concept of hedging and some regard derivatives as speculative products.

Hedging is a method of reducing the risk of loss caused by price fluctuations. Let’s take the example of a hypothetical investor – let’s call her V – who buys shares in Company X at Rs 100 per share. She wants to eliminate the risk of loss she may, therefore, buy a put option or write a call option. Buying the put option gives her the right to sell the shares at a pre-determined price of, say, Rs 100 per share. Let us presume the price of the Company X share falls below Rs 100. V has the right to sell her shares at Rs 100 per share because she is the holder of a put option. So, in case the price falls, she is protected. V pays a premium to protect herself in this manner. You could say the premium is a function of the market perception of risk. So option may be wiped off by way of premium.

Hedging can take place in a variety of ways. Suppose V manufacturers cotton shirts and buys cotton from the open market at the prevailing prices. Let’s say it takes a month to produce a batch of shirts. So cotton procured toady will finally be sold in the form of shirts after a month.

Shirt prices are found to move in tandem with cotton prices. V, thus, is exposed to the influence of cotton prices. In order to protect herself, she can simultaneously enter into a forward contract for the sale of shirts. That is, she can enter into an agreement with the shirt buyers, saying she will deliver shirts at a future date at a predetermined price. V is thus protected because the future price of cotton will not affect her.

Another thing V can do is to enter into a forward contract to sell cotton. Suppose the cotton used to make one shirt costs Rs 30 and other costs are Rs 20. So the total cost of making a shirt is Rs 50. What if cotton prices fall a month later, when the short goes up for sale? They will induce shirt prices to decline sales, and V will make a loss on shirt sales. If however, she has agreed to sell cotton at the current rate to be delivered when the shirt is sold, she makes a profit on the sale of cotton, which fully or partly offsets loss in her shirt business.

You may see that there is any number of ways in which one can assume a hedging position. You may also notice that typically hedging involves a trader contracting to buy or sell a particular good at the time of the contract, and also to buy or sell the same (or similar) commodity at a later date. So hedging is the process of entering into two simultaneous contracts of an opposite natures, with corresponding terms, one in the spot or cash market, and the other in the futures market. A loss in one contract will be offset by a profit in the other. Whatever the hedging technique adopted the purpose is to eliminate the risk arising out of price fluctuations; a position that is not matched with a contrasting position may simply result in an independent loss or profit.

If a hedging transaction is meant to offset the result of a regular business transaction, why hedge? The answer is that hedging eliminates unwanted risk. Following up the example of V, the shirt manufacturer, let’s say she seeks a profit of Rs 10 per shirt which is her value addition. She will make this profit notwithstanding her hedging transactions. Presuming that, based on her cost of Rs 50 per shirt she is selling them at Rs 60 apiece the loss or profit on account of fluctuations in the price of cotton will be eliminated; it will not affect he profit of Rs 10. If the manufacturer had neglected to hedge she could have made a greater profit or loss if the price of cotton increased or decreased over the period. Thus, normal profits are not eliminated.

However, there are some risks derivatives cannot address. It could also happen that, by the time V’s shirts hit the shop shelves, people’s tastes may have changed and the shirts may not sell. V cannot avoid this market risk associated with buyers’ tastes.