Hedging is the term used in the context of the stock market, many people use this term when they talk about the financial market but few people take care to explain this term to people who are new to stock market. Hedging does not help you in earning money but it helps you in lessening the potential loss and that is the reason why it is used by mutual funds, institutional investors, venture capitalist and sophisticated investors who are not looking for earning profit from hedging but looking to earn a constant return by reducing risk. In order to understand hedging better let’s look at some of the advantages and disadvantages of hedging –
Advantages of Hedging
- The first and foremost advantage of hedging is that it limits the loss for the individual so if a person has bought the car and he or she buys car insurance than it is nothing but hedging the risk associated with damage from accident to a car, fire in a car, and also damage from floods to car. So for example if due to accident there is car damage amounting to $5000 and if the insurance company bears the loss of $4000 then for an individual loss is only $1000 and not $5000 due to hedging
- Another advantage of hedging is that it can protect the profits for the person doing hedging. One can better understand it with the help of an example suppose an individual has 100 Microsoft stock at $100 purchase price and in cash market it is trading at $108 and he or she is not sure whether to hold or sell the stock, now if the price of Microsoft one month future is trading at $110 then the investor can sell in futures market at $110, thus investor does not have to worry about the price of Microsoft after one month and hence that profit of $10 is safe as far as investor is concerned.
- Hedging helps in increasing the liquidity in financial markets like the stock market, commodity markets and derivative markets because due to hedging people trade in different markets so that they can reduce the loss leading to ample liquidity in different markets which in turn results in better price discovery of asset under consideration.
Disadvantages of Hedging
- Hedging is not done for free as there are certain costs associated with hedging, so in the case of insurance there is insurance premium, in the case of derivatives there is premium and brokerage. Hence many people do not do hedging as they consider hedging expenses as unnecessary.
- Another limitation of hedging is that it limits the profit of the individual doing hedging because suppose in the above example if the price of Microsoft stock rises to $130 then an individual who has done hedging will get profit of only $10 and not $30 so due to hedging he or she will lose $20.
- Another limitation of hedging is that not all risks can be hedged and also all risks cannot be covered fully so in the case of insurance some loss has to be borne by the insured and in the case of financial markets also not all asset class have the corresponding hedge.
As one can see from the above that hedging has advantages as well as disadvantages and an individual before doing hedging should look at his or her portfolio and requirement as hedging is very good and beneficial in some cases whereas in some cases it is of no use and hence an individual should think and analyze whether his or her case belong to beneficial group or no use group.