A hedge is an instrument that aims to protect against the risks offered by fluctuations in the financial market. As stated at the beginning of the text, Hedge can be translated in e360 Power for example as coverage or security and aims to protect the financial operation from price variations of an asset, reducing its risk.
The practice emerged in the 19th century to fix commodity prices, limiting the risk run by rural producers. At the time, the instrument was called “fence and limit.”
A little more about what Hedge is: it is an instrument used to transfer the risk of an operation to third parties. In other words, it is a way for the company or investor to protect itself against fluctuations in the financial market.
The practice is regulated by the National Monetary Council (CMN) and can only be applied in situations that truly protect the company’s or professional’s business. Investors cannot use this strategy for speculative purposes – bets that aim to earn much higher profits than the average.
What Does It Mean To Hedge In The Financial Market
A hedge is a term widely used in the financial market, as it is a fundamental instrument to protect the investor against market risks, such as price variations. In this case, the investor who uses this instrument is more concerned with guaranteeing the price of a certain asset for a future purchase or sale than with the profit from the operation.
Later on, we will provide examples of how to apply hedging, and, in a practical way, you will understand perfectly what hedging is. But now, let’s explain the difference between two concepts that can confuse.
Difference Between Hedge And Swap
Have you ever heard of swap? The term, which means “exchange,” is a type of hedge contract. In other words, hedging, the term studied in this article, can be done differently. One of them is through swap.
Swap contracts must be carried out between parties, in which the profitability of assets will be negotiated, and the variation of each index will be discussed. Therefore, do not be confused: hedging and swap are different! Swap is just one of the ways to use hedging for protection. The swap consists of exchanging indexers (indices). Let’s say that a company invests in fixed income, such as the CDI, but as part of its operation, it purchases raw materials abroad, paying in dollars. It may want to protect itself against the dollar’s rise (preventing operating costs from increasing).
To do this, it will carry out a hedge operation and exchange the CDI profitability for the exchange rate profitability. This way, your operating cost will not be higher than the profitability of your investment.
Types Of Financial Market Hedges
Okay, you already understand what Hedge is, but there is more than one type to analyze!
The types of Hedge refer to the assets on which the strategy can be applied. Each type has a different purpose and function. Discover:
How Hedging Works In Commodities
The most common type is the Hedge used in commodities. It was even to protect farmers against variations in the price of their products that this instrument emerged.
This type of Hedge like hedge funds in austin texas for example aims to avoid the risks of supply and demand movements, preventing unpredictability from affecting market results. Hedging in commodities works based on futures contracts, in which producers establish a fixed price with their buyers, which will only be paid in the future (as well as the delivery of the products).
Thus, when rural producers can have a harvest forecast, they define the prices they consider fair for selling their products. This prevents a drop in prices in the event of high availability. The strategy also offers an advantage to the market, as it prevents scarcity from raising the price of commodities too much.
How Currency Hedging Works
Currency hedging is widely used by businesses that maintain commercial relationships with foreign companies. Regardless of whether for purchase or sale, it may be interesting for the company to establish a hedge contract that fixes the currency’s value at a number, protecting against the risks of exchange rate variations.
In this type of contract, swaps can be carried out, that is, the exchange of the index applied to the investment, changing its profitability. Currency hedging can be carried out through other strategies, such as buying the dollar (in which you buy the currency at a time of decline and hold it until it appreciates), which you can sell or use for payments. It is also possible:
Negotiate futures contracts and mini-contracts: you establish the right to buy or sell the currency at a future time, at a certain price;
Invest in foreign exchange funds: this is the most common model for investing in foreign exchange securities, so that your assets are linked to exchange rate variations;
Earn the right to buy the currency in the future: currency purchase options are ways of guaranteeing the purchase of the currency at the market price on the day the Hedge is contracted.
Okay, so what is Currency Hedge? Simple currency hedging is a way the company/investor uses to protect itself from the volatility of the asset and product market.