Hedging is a form of portfolio insurance that investors use to protect their money. While it will not prevent negative events from happening, it will protect the investor against the effects of the negative event. For example, investing in home insurance is a form of hedging to protect against fire, theft and other unforeseen disasters. Individual investors, corporations and portfolio managers make use of hedging techniques to reduce exposure to risks. In the financial market, hedging is bit more complicated because investors make use of one financial instrument to offset the risk of investing in another.
Price Risk Management
The risk of price movements in a physical market can be offset by locking in the price for the same commodity in the futures market. The physical market is also known as the spot or cash market where commodities like shares, grains, crude oil and other items are bought for cash and delivered immediately. In the futures market, delivery and payment is done on a specified date in the future. The date is determined at the time of commencing the transaction agreement. As per price risk management, the brokerage house would sell the investor's commodity when the top or bottom price, already agreed upon between the investor and broker, is touched upon. In other words, hedging allows the individual investor or corporation to lock in an acceptable forward price. When hedging is used in price risk management, windfall profits have to be sacrificed, but the upside is that it helps to protect against windfall losses. Hedging is used as a financial tool to manage price volatility.
Hedgers make use of futures to minimize risk in investment portfolios. Recently, futures were created on a variety of assets, moving away from traditional agricultural products. Futures on stock indexes and interest rates are now possible, providing greater investment opportunities for investors. Making use of futures to hedge investment portfolios equates to price risk transfer; the transferring of the price risk to someone (a speculator) who is willing to accept the risk to make a profit.
Lack of Protection From Federal and State Law
Hedge funds are not fully protected by federal and state law, as most registered investments are. Most hedge funds are not required to, and do not, disclose complete exposure potential to the SEC. While the SEC has the authority to investigate the background of a hedge fund manager, this is not a requirement. If a fraud is perpetrated, the SEC will investigate civil and department issues, but the bottom line is that hedge funds are not guaranteed or protected like bank deposits and other investment instruments.
For availing the services of a professional hedger, the investor has to sacrifice some funds. The investor need not pay fees to the hedger in advance, but a portion of the earnings would go down as commission charges. The commission percentage is agreed upon before the commencement of the hedging agreement. Individual investors who see slight movements in their investment portfolio should not subscribe for hedging services, as hedging does not provide substantial benefits for small movements in the asset prices.