Hedge — is a transaction effectuated to insure the trader from a possible future change in market prices for a product. Insurance is achieved by the conclusion of additional futures contracts along with the main trade agreement.
The first meaning of the word “hedge” in English is the fence. It’s not a coincidence. Hedges help investors to limit the risks in the volatile market and cover the possible losses.
This process allows investors, sellers, and buyers to transfer their risks to investment speculators, guaranteeing their prices. Speculators receive their profit, taking risks for themselves.
Classification of Hedges
Many financial products are used as hedges. They are called derivatives. A derivative is an instrument whose value depends on the basic asset or group of assets or is a derivative of them. This is the type of contract between the parties that take on the obligation to transfer the specified asset (or the amount of money) in a particular period and at a certain price. Derivative allows the investor to compensate for the adverse change in the price of the asset.
Types of derivatives:
Futures — is a contract for the purchase of exchange goods with a long period of calculations. The investor shouldn’t pay the entire contract. He reserves only warranty support from the broker. This amount is a guarantee that at the end of the deadline, the calculations will be executed, or the investor will close the position before the expiration of the deadline.
Forward — is a sale of the asset for a while in advance at a low price. This hedge allows the trader to get a stable profit that won’t change in the future.
Swap — is a tool that is used when the transaction participants exchange some goods or conditions. Usually, the swap helps to hedge the interest rate (currency swap), the prices for commodities (commodity swap), and risky strategies on the security market (stock swap).
Option — is a contract that allows the trader to buy or sell an asset for the previously indicated price.
Taking into account these types of hedges, we can make their classification.
Types of Hedges:
Long Hedge — is a purchase of a futures contract to protect oneself against a possible increase in prices.
Short Hedge — is a sale of a futures contract to protect oneself against a possible reduction in prices.
Pure Hedge — is an urgent purchase order concluded to “lock” the loan percentage and thus prevent the possible fall of the lending rate.