Every business is coined with the risk of operation it could be at any level or any means that can be detrimental to the business. One part of such risk which can hit the business strongly is the financial risk. The owners must be vigilant to check out all the possibilities of such kind of risk and make ways to prevent it and manage it. This will help in the proper and smooth functioning of business without much hindrance.
The investors also need to understand the risk of putting their money into the business before they decide on the firms in which they invest and also understand the level of risk management by these companies. This is when the need for the strategies to manage the risk arises. Some of the common ones which we may have heard are arbitrage and hedging which are the most common financial risk management strategies.
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Hedging can be defined as the reduction of uncertainty when there is price change in any asset. It is simply the bearing of loss from an investment. One best example for a quick understanding is the life insurance policy we take which may help our family at the time of our death. Hence that which helps to bear an unforeseen event can be termed as hedging in financial terms.
Hedging can be of use in the areas like
- Commodities – this may include agricultural industry products, energy industry or metals.
- Securities: investing in shares and equities
- Currencies: the dealing in foreign exchange between currencies
- Interest rates: lending and borrowing rates could be risky when they are not in favor of the person.
- Weather: interesting to note that even weather is an area where there is hedging.
The types of hedging can be in terms of futures, forwards or money markets.
- A future contract is that which deals with buying or selling a product at an agreed price and is a standardized contract.
- A forward contract is an unstandardized contract which deals with the buying and selling of products at an agreed price and specified date.
- The money market is the essential criteria where there is short-term buying, selling, lending and borrowing take place in the duration of one year.
The hedging strategy is the method to reduce the severity of risk in any business. There is no standard strategy in this as it has to be modified according to the situation in the business.but the very common strategies are :
- Hedging through asset allocation
- Hedging through structures like making portfolio choices to reduce risk
- Hedging through options.