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Hedging – what is it in a simple example

Hedging – what is it in a simple example

Hedging is a banal insurance of risks in a trade transaction.

This terminology is used in trading any assets with the parallel use of financial instruments (derivatives) for its insurance.

What does it mean and how does it happen

When trading on the market, an investor either buys or sells an asset, which is usually stocks, indices, commodities, crypt, currency, etc.

Buying or selling them is carried out for commercial purposes – to make a profit due to price growth (long), or its fall (short).

In any such transaction, there is a risk that the price may go the wrong way. To avoid such a scenario (possible losses), the investor prefers to insure such a transaction, i.e. he hedges it.

Of course, an investor could go to an insurance company and conclude an agreement with it that if the price of his asset, for example, falls, the insurance company will pay him a certain compensation to offset this risk.

But in practice, of course, insurance companies do not provide such services. Therefore, for these purposes, investors use certain financial instruments provided by the market itself.

hedging is the essence on a simple

An investor usually hedges a trade transaction by buying a financial derivative, the most liquid types of which are:

  • futures
  • swaps
  • options
  • forward contracts, etc.

These derivatives are completely speculative instruments and are both exchange-traded and over-the-counter. t.E. they can be bought/sold as on exchange, if we are talking about liquid assets (gold, currency, crypt, etc.), and outside it, in the form of an individual transaction.

Speculative – because it is, in fact, a bet with a certain market participant and his desire to make money on the fact that something can rise or fall in price, and nothing more. They are not interested in real assets – everything is done for the purpose of resale.

That's due to the fact that there are such speculators on the market, trading transactions can be insured or otherwise hedged.

A simple example is hedging a transaction using a forward contract.

You are a farmer and plans to grow 1000 kg of cucumbers and sell them in 2 months at a price of $ 1 per kg, i.e. the volume of planned revenue is 1000 x $ 1 = $1000 and it is break-even for you.

This is a market and naturally there is a risk that the price may change in 2 months, taking into account the overall yield and external factors affecting it.

You find someone (a speculator) who is ready to buy these cucumbers from you in the amount of 1000 kg for $ 1 per kg in 2 months, regardless of the market. As a result, a forward contract is concluded with him on such terms.

That is, you have already insured yourself, in fact hedged your deal and transferred all the risks to another (speculator).

If in two months the price becomes $1.5 per kg of cucumbers, then your lost profit will be 1000 x ($1.5 – $ 1) = $ 500, but even if the price drops to $ 0.7, then you will stay with your own and will not lose 1000 x ($1 – $ 0.7) = $ 300.

In fact, hedging provides an investor with the opportunity to save his capital due to the fact that there are speculators in the market trading all the same financial derivatives.

A similar essence, but with some nuances, and in hedging risks with futures, options, etc.

Hedging – what is it in a simple example – Something like that!

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