What is Hedging?
Hedging is a technique that allows a trader to mitigate the potential losses of an investment by minimizing the potential gains. This results in profits for the investor, but more importantly minimizes risk. Hedging can be accomplished using various methods, such as buying stock in multiple companies or rolling contracts of some other type.
Hedging as observed by Fintalent’s Hedging Consultants is basically a risk management tool. It’s slightly more complicated than that of course and to give you a better idea; we’ll now take a look at what hedging it actually involves.
If you’ve ever purchased an asset such as currency, shares or an investment fund then you’ve put your money at risk. The price of the asset can move up and down in value, this means the value of your portfolio can also change and even lose money. So the important job for hedgers is to help protect against this risk, keeping the value of their portfolios fairly stable. In financial markets, hedging is usually all about mitigating the risk of the unexpected.
For a currency trader, hedging may involve taking an opposite position in a currency that is known to move in the opposite direction of their main position. For example, if you are long on EUR/USD then you could consider shorting USD/CHF as a hedge. This will mean that should your EUR/USD trade move against you then at least some of your losses will be offset by profits made in USD/CHF.
As a result, hedging is often used to minimise or completely eliminate any unwanted risks that may arise from being exposed to another financial asset or market.
Hedging can be used in all types of financial markets, not just currency trades. It can be used to help traders manage risk in investment funds and even within trading accounts. In other words, it should be understood as a firm way to minimise risk for any type of trader or investor.
Hedging with Pensions
A pension is one of the best places to hedge your investments as it provides very simple, easy to understand and transparent hedging opportunities. If you have a pension then you may already know that there are specific accounting rules that govern how pensions should be managed by their managers; however, those same rules often include hedge accounting rules which allow examples of hedged investment positions.
For example, if you have purchased a pension fund that contains investments in shares; and if the price of those shares falls, it is likely you will end up with an extra profit or loss on your record. However, from a finance point of view it is your business to ensure you have taken this into account when calculating your net worth.
The way you go about doing this is by using hedge accounting for the cost of keeping the investment in this position and then subtracting that from the original cost of buying the investment. If you want to see an example of how this works there are some great examples taken from actual pension cases in these very pages (click here and here). You can also see an example of how hedge accounting is used for a profit in one of our posts on hedging your profits here.
The main thing to remember when it comes to using hedge accounting is that in order for it to be allowed, there must be an existing hedge. So, you need to prove that the two assets are going up and down at the same rate, if they aren’t then they are not a hedge and the accounting rules will not allow you to use this method.