Question

Explain why hedging is like buying an insurance policy. To buy an insurance policy, you need to pay a premium; what is the corresponding premium in hedging? Give an example to clarify your answer.

Answer 1

Hedging is an insurance-like investment that protects us from the risks of any potential loss of our finances. We can protect ourselves from the risk of loss by hedging our future position by paying a fixed amount of money which is similar to a insurance policy premium.

A hedge is an investment which has a similar purpose as to that of insurance policy. The purpose of both is to eliminate or reduce the risk by offsetting the potential loss. If we are reducing the risk through hedging, then we might reduce the reward also as we have to pay a price to hedge our position which reduces our profit but saves us from the potential risk of huge losses. Hegde can be exercised through various financial instruments such as forward contracts, futures, options.

In case of a manufacturing organization that supplies its products in the locally and is also involved in exports. Assuming that it’s exports 80% of its goods. The company will have an inflow of foreign currency as it exports major portion of its production. The value of this foreign currency keeps on fluctuating daily and could lead to gains or losses.

In order to restrict this potential loss, the company can enter into a contract with a bank to sell their foreign currency at a fixed rate by paying the fees/premium for the same. In this way the position of the company is secured in case of adverse movement of foreign exchange.

Hope I am able to solve your concern. If you are satisfied hit a thumbs up !!