Hedging is Not the Same as Risk Control
What is hedging?
Hedging is a technique designed to reduce or eliminate financial risk. For example, taking two positions that will offset each other if prices change. There are many specific financial vehicles for this, including insurance policies, forward contracts, swaps, derivative products and futures contracts.
Futures markets were established of agricultural commodity prices. Since then they have included futures contracts for hedging the values of shares, energy, precious metals, foreign currency, and interest rate fluctuations.
In commodity market farmer sell future of his crop to get the price fixed before he actually bring the crop to the market. When farmer cultivates the crop, he settles it with future price and he is not concerned with the current market price.
What is the Difference between Hedging and Arbitrage?
Unlike arbitrage, hedging does not necessarily involve in uneven priced assets. The main difference between hedging and arbitrage is that arbitrage focuses on profits while hedging focuses on lowering risks.
Type of Hedging in stock market.
Stock portfolio can be hedged by taking an opposite position in futures to protect your stock picking. There are many methods to hedge shares in the stock market.
One kind of hedge is stock vs. index. Trader sells S&P Nifty of the same amount of value, of which trader has bought 1000 Reliance ind. Ltd. Or the other way, if he short sell the 1000 Reliance, he buys the Nifty of equivalent value.
Another kind of hedge between same industry sector. If a trader buys 1000 shares of Tata Motors Ltd., he sells the equivalent value of Maruti Industries Ltd.
Third kind of hedge between index, stock and options. If a trader buys index or stock, he also take position in call or put by selling or buying it.
Why hedging is not the same as risk control?
Hedging the risk means eliminating risk, if the market are NOT inefficient. Inefficient market drives crazy, any systematic calculation can go wrong. One and two type of hedging can go wrong.
The eliminating risk also means that the potential return will be approximately equal to the risk-free return. The Premium you pay on buying put-call can be zero at the end of settlement and if it’s not, you are not the beneficial. For example, it is like your medical insurance premium, once you paid -it’s out of your pocket. Premium will not be beneficial to you, if you get sick or not – it just pay your hospital bills.
Hedging can definitely protect from the giant loss, if the markets are volatile. But there is always a weight on your profits to protect from uncertain risk. Sometimes it’s better to avoid both the trade than hedging it.
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