how does one hedge, or protect themselves from economic risk?

Expert Solution

Introduction

Hedging is particularly utilized by Portfolio managers, investors, and companies to reduce their exposure to various risks like economic downturns, unsteady political climates causing impact, war, etc. In the case of financial markets, hedging against investment risk means strategically employing certain financial instruments and strategies to discout adverse price movements caused by risks. In simpler terms, investors hedge or protect one investment by making a trade in another.

Common Hedging Techniques

Derivatives are the most commonly used hedging instrument of which, the two most utilized ones are are options and futures. With these instruments, the investors and corporations can develop trading strategies where the risk of a loss in one investment is offset by a gain in a derivative.

Hedging Against Potential Economic Downturn (or Recession)

In detecting and hedging for a market recession or an economic risk triggered by a macro event (example: COVID-19 pandemic), investors should closely watch the important catalysts, including GDP, currency valuations and also the real estate markets, all of which have a high influence on the valuations of the equity markets. If negative reports occur especially in the emerging markets, there is a risk that this might lead to market losses and call for a shift in assets to safe havens and hedging strategies.

One method of hedging against economic risks potentially caused by emerging markets is to invest in risk-free assets like the Treasuries and Treasury Inflation Protected Securities, United States government bonds and United States corporate bonds of high-credit-quality companies.
A second strategy for protecting and quite possibly gaining a profit from the losses incurred by an economic downturn is a trade that involves buying domestically oriented ETFs (exchange traded funds), and short selling country-specific emerging market ETFs.
Some of the other strategies include taking a one-sided short position against a specific country. Example: Short selling the iShares Currency Hedged MSCI Emerging Markets ETF (NYSEARCA: HEEM) for protection against currency risk.
Another strategy might include short selling the index through put options on the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM).

jeff jeffy answered 1 year ago

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how does one hedge, or protect themselves from economic risk?

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