Question

Explain what the management needs to consider in the hedging strategy selection process

Answer 1

Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging strategies typically involve derivatives, such as options and futures contracts. The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event's impact to their finances. This doesn't prevent all negative events from happening, but something does happen and you're properly hedged, the impact of the event is reduced. In practice, hedging occurs almost everywhere, and we see it every day. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. Keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

1. Hedging is employed in the following areas:

• Securities Market: This area includes investments made in shares, equities, indices, and so on. The risk involved in investing in the securities market is known as equity or securities risk.
• Commodities Market: This area includes metals, energy products, farming products, and so on. The risk entailed in investing in the commodities market is referred to as the commodity risk.
• Interest Rate:This area includes borrowing and lending rates. The risk associated with the interest rates is termed as the interest rate risk.
• Weather: This might seem interesting, but hedging is possible in this area as well.
• Currencies: This area comprises foreign currencies and has various associated risks such as volatility and currency risk.

2.Types of Hedging Strategies

Hedging strategies are broadly classified as follows:

1. Forward Contract: It is a contract between two parties for buying or selling assets on a specified date, at a particular price. This covers contracts such as forwarding exchange contracts for commodities and currencies.
2. Futures Contract: This is a standard contract between two parties for buying or selling assets at an agreed price and quantity on a specified date. This covers various contracts such as a currency futures contract.
3. Money Markets: These are the markets where short-term buying, selling, lending, and borrowing happen with maturities of less than a year. This includes various contracts such as covered calls on equities, money market operations for interest, and currencies.

The AMCs generally employ the following hedging strategies to mitigate losses:

1. Asset Allocations: This is done by diversifying an investor’s portfolio with various classes of assets. For instance, you can invest 40% in the equities market and the rest in stable asset classes. This balances your investments.
2. Structure: This is done by investing a certain portion of the portfolio in debt instruments and the rest in derivatives. Investing in debt provides stability to the portfolio while investing in derivatives protects you from various risks.
3. Through Options: This strategy includes options of calls and puts of assets. This facilitates you to secure your portfolio directly

Factors effecting hedging decision by a company

1. The growth opportunity measured by the market to book value has a positive and significant effect on the Hedging decision, growth opportunity positively affects on hedging decision with derivative instruments is accepted.High growth opportunity of a company can show that the company has a good market value among other companies. Developing companies tend to use many alternatives in their funding. The proxy used to measure growth opportunity is MVE/BVE that is the ratio between market value of equity and book value of equity, this ratio reflects that the market assesses the return of the firm's future investment from the expected return of its equity, the difference between the market value and the book value of equity indicates a growing opportunity for the firm

2. Leverage ratio is a ratio that measures how far a company's ability to funding with debt (Brigham dan Houston, 2006). The leverage ratio used is Debt to Equity Ratio (DER). DER is one of the financial leverage ratios that provide information about the company's ability to repay the debt with the equity owned by the firm, DER is the ratio of total debt compared to the total equity owned by the company.The leverage measured by debt to equity has a positive and significant effect on the hedging decision,leverage positively affects the probability of using a derivative instrument as a hedging decision is accepted.

3. FIRM SIZE : Large companies tend to use hedging derivatives to deal with risk exposure rather than small firms because they have the necessary resources and knowledge to do so. The size of a company is a company scale that can be seen from the total assets of the company. Company size is formulated as followsThe firm size variable measured by Ln total asset has a positive and significant effect on the hedging decision firm size positively affects the probability of using a derivative instrument as a hedging decision is accepted.

4.Advantages of Hedging:

• Hedging limits the losses to a great extent.
• Hedging increases liquidity as it facilitates investors to invest in various asset classes.
• Hedging requires lower margin outlay and thereby offers a flexible price mechanism.

Hedging provides a means for traders and investors to mitigate market risk and volatility. It minimises the risk of loss. Market risk and volatility are an integral part of the market, and the main motive of investors is to make profits. However, you are not in a position to control or manipulate markets in order to safeguard your investments. Hedging might not prevent losses, but it can considerably reduce the effect of negative impacts.