When we invest in an asset there are chances of having unfavorable movement in the price. To lower this risk and investment known as ‘Hedge’ is done on that asset. This hedge takes the position that is offset in that particular security similar to a Futures Contract.
Hedge In Depth
The insurance policy that we take is something that is comparable to hedging. For example: for instance let’s consider that you have taken a house in an area where there is often chances of earthquake striking, in this case, one would like to secure this asset as they have invested in this or we can also say that they want to hedge it. They can do so by taking an earthquake insurance policy on their house. When we do trading there is a ‘risk-reward tradeoff.’- meaning it is the proposition that if there is increased risk, there is an increase in the probable return as well and in hedging, there is a built-in risk. Since it reduces the possible risks it also takes away possible gains as well. Therefore we can say that hedging comes with the price. When we take insurance for an earthquake, the payments must be made every month, however, suppose the earthquake doesn’t occur the money they have paid is not given in return to them. But if you think of it losing little money is better than losing the entire asset is what many people believe in.
When a positions risk is completely eliminated it is known as a ‘Perfect Hedge.’ We can also say that hedging is fully or 100% inversely proportional to an asset that is vulnerable. This is something that is considered true and rather than in reality where the hedge is perfect hypothetically it is still not free. If the asset and the hedge do not move in the expected direction that is opposite direction it is referred to as basis risk and in this, the basis is nothing but the variation.
Hedging With Respect To Derivatives
Derivatives or contracts are financial assets that are tradable which make the movement in terms of the assets that are underlying which may be one or more than one. The securities may include the following
- Futures contracts
- Forward contract
And on the other hand, the underlying assets may include the following
- Interest rates
The relation between the underlying assets and derivatives is defined very clearly as derivatives can be considered as an effective way of hedging on their respective assets.