What is hedging? Why does everyone do it?

Ever heard of the words hedging in profession & business world & got confused? Did you feel uncomfortable asking your colleagues about it? Did you try reading about it on the internet only to find everything a bit over the head with all the jargons? Well please give me a chance to cover the basics in a layman's language. Because that's what we do in "Teach a Novice!!!" section.

Introduction

Hedging refers to protecting yourself from unforeseen events. In technical terms, it is a risk management strategy. Risk may be with respect to losses or lower returns. However, we should note that it does not mean avoidance of negative events but limiting the negative effects due to unforeseen negative events. But everything comes at a price in this world!!! And the price for hedging yourself from unlimited losses is depriving yourself from unlimited profits as well.

As it is said in finance - "High risk high rewards, low risk low rewards".

Example

Let us say,

• You reside in India & sold goods worth $1,000 to someone in USA receivable one-month later. USD to INR FX rate is 80. So you have a receivable of INR (80 x 1,000) = INR 80,000 after one month.

• However, you worry that there might be some international geo-politics news coming in which might lower the FX rate to 70. Hence, worry for a loss of INR [(80 - 70) x 1,000] = INR 10,000.

• So you go to your banker & express your concerns. He gives you a solution. He drafts an agreement that "irrespective of FX rate prevailing one-month later, the bank would pay you $1,000 at FX rate 78, i.e., INR 78,000".

• But why would bank do that? Because the bank believes that the FX rate will not fall below 78 & hence it would profit from the transaction.

• What happens now? Irrespective of what the actual FX rate happens to be, you will get INR 78,000. Hence limiting your loss to INR (80,000 - 78,000) = INR 2,000.

How should you feel about it?

• You might think that you successfully avoided loss of additional INR 8,000 (INR 10,000 - INR 2,000), but you have also foregone the possible opportunity of profiting from favourable movement of FX. Say if FX would have been 85, then you would have made additional INR [(85-800) x 1,000] = INR 5,000.

• Hence, you should neither feel happy nor sad. You should feel relieved that you should not stress about FX rate & focus solely on your business.

Because that's the whole purpose of hedging, "relieving yourself of stressing out on things that are not under your control".

Hope it was a value addition for you & you liked it!!!