Question

What are the 3 different types of hedging techniques? Mention 2 examples for each.
(Forward hedge, future hedge, money market hedge)

Answer 1

✓ Meaning of hedge: Hedge helps to reduce the risk of investment. Hedge refers to try to decrease the risk of investment through a proper offsetting investment. Hedge reduces the level of actual risk in any investment.Hedge refers to the strategy used to make minimum loss in case of if there is any change in the price of the investment which is in the form of securities, commodities as well as currencies.

✓ Types of hedging techniques: There are three different types of hedging techniques which are forward hedge, future hedge and money market hedge.

a) Forward hedge: Forward hedging simply means when two parties or two person agree to buy a particular thing at a decided price at the maturity time. In this technique of hedging both the partupa are having obligation to perform their part of work. Example:A] suppose there is one farmer and one shopkeeper. Farmer is growing rice and the shopkeeper is selling the rice. They both is doing forward contract that after completion of 3 months shopkeeper will buy 100 quintal rice from farmer at a $ 50 dollars per quintal. So, in this case shopkeeper has to buy the rice from the farmer at a predefined rate. So, this will help to reduce risk to both the parties.

Example: B] Suppose there is a person who wants to sell the house at $250000 and another person who wants to purchase the house but at present he is not having enough money with him. So, they both make a forward contract to purchase the house at $260000 after 1 year. So, in this contract at maturity time whatever the position both parties have to perform their parts. So, this helps to reduce the risk of both the parties.

b) Future hedge: ​​​​​​ Future contact hedging is a technique in which both the parties make a legal contract and standerdized contract to perform a predetermined action at the time of maturity or to buy or sell an underlying asset at a predefined price. Example: a] Suppose a company know that they will need a copper a 2 months, and they will need 50 kg of copper. Price of copper currently is $2000 per kg. And price of future contract is $ 90000. If company purchase the contract company will be sure about the price is $ 90000. This will help to reduce the risk of a company.

Example: b] Suppose a person wants to a U.S. dollars after six months and price of U.S. dollar currently against (chinese)Yuan is 8. If a person is able to get at 7 Chinese Yuan if he do future contract. So ,if he make that futures contract than that will be helpful him to reduce the risk.

c) Money market hedge : Money market hedge helps to reduce the risk against the foreign currency. Example:a] Suppose there is a company who is exporting goods to other countries. Company is having risk of exchange rate changes. If company make contact about exchange rate with a person or a bank it refers to the money market hedging. It helps to reduce the risk of loss which can accure due to changes in exchange rate.

Example: b] Suppose you are living in Europe with your family and you wants to go America for business tour after six months. In this case if you make contact with the travel agent about exchange rate then it will reduce risk for you. This can be considered as money market hedge.