Hedging is often seen as an advanced investment technique, but the hedging concepts are relatively basic. With the rise of hedge funds — and subsequent criticism — the practice of hedging became more common. In comparison, many hedge funds carry on the possibility of investors having to move abroad. By taking on the extra risk, they expect to benefit from the benefits the accompany them.
Everyday Hedges
Most people have engaged in hedging, whether they know it or not. For example, in the case of your death, when you purchase life insurance to support your family, this is a shield. You pay the money in monthly amounts for an insurance company’s coverage.
Although the concept of hedging in the textbook is an investment taken out to minimize the risk of another investment, insurance is an example of a hedge in the real world.
An Example of a Typical Hedging Strategy
Hedging is best demonstrated by one illustration, in the Wall Street sense of the word. Imagine you want to invest in the bungee cord manufacturing industry which is on the rise.
You know of a company named Plummet that is revolutionizing the materials. Also, the designs to produce cords that are twice as good as their closest rival, Drop. Then, you think the share value of Plummet will increase in the coming month.
Unfortunately, the production industry of bungee cords is also subject to abrupt changes in legislation and safety requirements, which means it is very unpredictable. In other words, it is an industry risk.
And you believe in this company; you just want to find a way to reduce the risk to the industry. In this scenario, you’ll hedge by going on Plummet long while shortening its rival, Drop. For each company the value of the participating shares would be $1,000.
When the market as a whole is going up, you’re making a profit on Plummet but losing on Drop. For example, if someone dies bungee jumping, the industry takes on a hit, you lose money on Plunge but make money on Drop.
Basically, in favor of less industry risk, the minimize goes for the net benefit – the income from going long on Plunge. In other words, it is as a pair trade. In addition, it helps investors gain a foothold in competitive industries or find businesses in sectors with some form of systemic risk.
