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The Concepts of Hedging: Origins & Approaches

Introduction

Business investments usually undergo many fluctuations caused by changes in financial prices and market demands. Common examples of financial prices include interest and exchange rates, goods, services, and equity costs. Due to the unpredictability nature of prices and rates, it is necessary for organizations and business units to take precautions when planning on investments. Companies should always integrate risk aversion techniques, which apply almost the same principles as those used in insurances. Portfolios adopted by organizations should help in positioning such organizations in good financial environments so that, in case value fluctuations occur, there is the assurance of survival. Although it is impossible to eliminate the occurrence of risks resulting from price and rate fluctuations, at least the implementation of good risk aversion measures can help an organization shield itself from the severe impacts of such changes.

Hedging

Primarily hedging is a financial plan that organizations and individuals adopt to ensure they minimize the risk of losses resulting from investment in global money markets using contracts. Hedging almost works under the same principle as insurances in reducing risks of losses, but in some market situations, it may reduce gains from investments. The whole process involves selling and obtaining similar amounts of merchandise almost at the same time in different markets. Organizations apply this strategy with expectations of good future gains based on assumptions that fluctuations in one market have less impact on prices in another market (Wisner and Hurt, 2002, pp.1-3). For example, in the wheat business, the majority of grain buyers purchase wheat from different nations and sell the same via future contracts. When this wheat reaches the required market the same dealers purchase back what they have previously sold as future contracts. This strategy helps to ensure price fluctuations as the wheat moves from market to market have minimal impacts on the final prices. Financial markets apply the same principle, whereby individuals use options and warrants to ensure risk reduction. The primary assumption, in this case, is that purchase of shares with the same call options means; change in the price of shares purchased may alter the value of such shares, hence expectations of losses (Hedging, 2009, Para. 1).

Another common industry where hedging finds wide application is the airline industry in the purchase of jet fuel. Due to the volatility of fuel prices, the majority of firms in this industry use futures contracts on crude oil to ensure the occurrence of future fluctuations in fuel prices does not affect their normal operations.

How to Conduct Hedging

Hedging applies financial instruments called derivatives in most cases futures and options. Derivatives are forms of collaterals whose worth depends on specific assets such as currencies, interest rates, bonds, and market indexes. Currently, existing classes of derivatives include options, forward contracts, and swaps. In most cases, organizations use derivatives as speculative measures of reducing losses. For example, Canadian investors interested in obtaining Australian shares will have to face risks resulting from exchange rates throughout the period they own the shares.

Investors can use the following methods in hedging namely: the neutral and, beta-neutral approach. In a neutral approach, organizations calculate values of stock to be traded using the same dollar values in the future. On the other hand, beta neutral tries to merge stock amounts and indexes in a historical view. For example, if the beta of Nokia Company is four, then for every 2000 GBP long position in Nokia, one has to hedge with a 4000 GBP amount of short position in the real financial market.

Although investors have strong attachments to certain financial organizations, there never lacks incidences of doubt about the viability of such organizations. Hence, for one to protect self-interests and avoid unpredictable losses, they should purchase derivatives depending on assets owned. This helps to ensure they have to sell rights as concerns specific strike prices. In addition, this strategy ensures if a backdrop occurs in share values to amounts less than their strike price, the put option will cater for that (Chadha, Mathieson and EIchengreen, 1997, pp.69-83). For example, if Sounders Company is not sure on the viability of business gains from Deco, due to fluctuating marketing prices, the company can sell its products on contract so that later as business advances and prices stabilize it can obtain back the same commodities using the contract price.

Hedging is also necessary because it helps organizations maintain their competitiveness in financial markets. Competition forms the main backbone of any business operation in local and international financial markets. In this regard, investors should adopt correct risk management programs, which will place them at a competitive advantage as compared to other competing companies in the same industry. Organizations should adopt this to minimize instances of pricing out, caused by fluctuations in market prices due to trade diseconomies.

Problems of Hedging

The main obstacle when making decisions on the nature of hedging policy to adopt is deciding on policies that will ensure uncertainty in prices and business losses resulting from such choices are at par. This is because, before deciding on any policy that an organization will adopt, organizations should take into consideration the needs of all stakeholders. One thing all organizations’ management teams should always put in mind is that the adoption of certain hedging measures is a main strategic decision, whose impacts on a firm are affects many investors. For example, if the organization sells almost 75% of its products in the international market say the U.S., the dollar exchange rate determines the prices of its products. Due to many fluctuations in the U.S. economy, there is the likelihood of losses, hence a major problem may arise at some point with stakeholders.

Points to Consider Before Adopting a Hedging Strategy

The majority of investors always aspire to invest in financial organizations with hopes of good gains, hence the selection of companies to invest in should consider the competitiveness of organizations in that sector. One thing that all investors should note is that any time-shares shoot in prices there is a likelihood of loss occurrence, hence whichever the hedge policy adopted critical evaluation of investing companies should form the main basis of any decisions made. For example, if an organization wants to invest in two companies critical consideration on investor portfolio should give one the best option to take depending on whether such investments are short or long-term positions. This is because price fluctuations are never easily determinable by current market prices but instead changes in economies (Koziol, 1990, pp. 32-56).

Generally, organizational goals always direct all decisions and options chosen by organizations as concerns investments. Organizations should choose options that ensure the minimization of the variability of incomes. This relies on the same principle many investors use when deciding where to invest based on organizations’ proficiency in certain business areas. Organizations should ensure they avoid the notion that involvement in forwarding outright business deals helps to alleviate foreseen losses that may result from market price variations (Chadha, Mathieson and EIchengreen, 1997, pp.1942-1945).

Secondly, at all-time investors should take into consideration all-available hedging tools and the effects of their application in differing business scenarios. This should take into consideration fluctuations in prices and market exchange rates of world currencies. Hedging tools that organizations should adopt should limit business operations according to specifications by shareholders and other interested parties. In addition, hedging strategies should use specific hedging modes that work in specific business environments, under specific prevailing economic conditions. One main factor that managements should remember is that; different hedging tools work differently in varying economic conditions, hence the success of such policies depends on correct decisions by managements (Sooran, 2009, 26-33).

The third and main factor that management teams should consider before venturing into any business is the risks faced during normal business operations. Price risks faced by companies are of three types namely: transaction risks, translation risks, and economic exposure. Transaction risks that organizations face originating from abrupt changes in commodity prices. This is in turn is reflected in outcomes from any business venture in unknown markets. Translation risks result from fluctuations in currency exchange rates, hence mostly affecting international business ventures. On the other hand, economic exposure is more to companies’ operations in local business environments. For example, rapid devaluation in market economies affects organizations that primarily depend on local markets. This is because most international companies will always aim to achieve maximum gains by outsourcing in international markets, with less consideration on local companies (Bourdos, 2008, pp. 1-4).

Merger arbitrage is one of the common examples of hedging strategies that organizations adopt. Here an organization invests in stocks of firms in the process of merging. This strategy can only be successful if organizations have the know-how of such mergers early before they occur. For example, firm X may be selling 20 shares for every 16 shares they ought to purchase from company W. consideration of existing market values organizations can pre-determine the exchange ratio in terms of taking over offers. If such calculations predict reduced stock price as compared to take over values such a deal is viable (Hedge: finance, 2009, pp.1-2).

Conclusion

In conclusion, the correct adoption of good hedging techniques can help investors deal with many risks that may result from investments in financial markets. Although many business ventures always aspire for bigger profits from their ventures, one thing, which is not avoidable, is the occurrence of risks. In most cases, the majority of risk aversion policies adopted by investors do not help to deal with factors related to risk-return trade-offs. Organizations should note is that reduction of risks in most cases implies that the amount of gains from ventures will also reduce, hence the need to balance strategies of risk aversion.

Reference List

Bourdos, D. (2008). Revisiting currency hedging: a second chance? TD asset management. Web.

Chadha, B., Mathieson, D. & Eichengreen, B. (1997). Hedge funds and financial Markets dynamics. New York: John Wiley and sons.

Hedge: finance. (2009). Economic expert. Web.

Hedging. (2009). Financial glossary. Web.

Koziol, J. D. (1990). Hedging principles, strategies and financial markets. New York: John Wiley and sons.

Sooran, C. (2009). What is hedging, why do companies hedge? Business pipeline. Web.

Wisner, R. N., & Hurt, C. (2002). Principles of hedging with futures. Web.

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