Lecture notes
What is hedging
- Institution
- London Metropolitan University (LMU)
This document provides a definition of hedging. In addition, this shows how to hedge and the disadvantages of hedging.
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What is hedging‘Hedge funds are funds that seek to make investors’ money regardless of the direction in which
markets are moving it.’ (Pilbeam, 2010). Hedging helps investors to reduce the impact of risk of a
negative event that can occur.
How to hedge
The most common method of hedging is through derivative product. Derivative product are
financial instruments based on the underlying securities like bonds, shares and currency. In this
scenario they are five derivative products (HSBC, Sky and Astra Zeneca shares and Aston Martin
and Tesco bonds) that can be used to hedge. Derivative main mission is to oppose against
variation in return by providing a contractual agreement to enable exchange at future date at a
fixed price.
Forward contracts is a way hedging of HSBC, Astra Zeneca and Sky shares and Aston Martin
bonds and Tesco bonds. Forward contract is the simplest derivative product that can be
contractual agreed between two parties. In order to turn the three shares and two bonds in to
forward contract they would need to make an agreement an exchange at a future date at a fixed
price. For example, for Tesco would import oil from the producer. There would a price quote for
three months in advance at a fixed quantity. The price will have a premium for risk and cost of
administration. On maturity date Tesco will buy the oil at the contracted price and quantity and
price may be more or less than the spot price.
Future contracts are an alternative way of hedging. Future contract is an agreement to purchase or
sell an standardised amount of the underlying assets at a future date at a cost viably decided at
this point. Future contract would be a ideal way of hedging the three shares and two bonds as
future contracts traded on the London International Future and Option Exchange which is very
liquid market to invest in. Unlike forward contracts if the underlying asset falls behind maturity there
is a right to closed off early. In addition, future transaction would result to making a deposit which a
fraction of the price of the underlying asset, however commission is charged for buy or sell the
asset from the brokage. There would be credit risk between different parties and each party are
required to make a deposit a margin with a bank.
Disadvantages of Future contracts
One disadvantage of future contract is that there is a lack of variation of assets
The maturity date is restricted
Block of contracts is not detachable
Disadvantages of Hedging
In addition, some hedges are expensive regardless of whether markets stay neutral. Like any
protection item, costs of hedges for the most part convey a upfront expense, and the hedges party
normally needs to consider that consequence against any benefits from the position or add it to
any misfortunes.
At long last, some investors despise when organizations have hedges. They need risk s of the
business and consider hedges to be a hindrance to their very own hazard the board as financial
specialists. Particularly when hedging doesn’t work out, a build-up of investor pressure can force
companies to remove hedges.
As a result, Hedging has it advantages and disadvantages, however I think that advantages
outweigh the disadvantage of hedging because hedging acts like an insurance for companies like
Tesco, Sky, Astra Zeneca , Aston Martin and HSBC. Hedging helps reduce the negative impact of
risk for companies, even though this can be an expense it is worth to reduce risk in a company as
much as possible
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