What is Hedging?
Financial institutions use Hedging to increase financial stability and reduce the risk of financial distress. Broadly, there are several types of Hedging, including static Hedging and dynamic Hedging.
Static hedging is a simple process that determines the initial risks of an investment position. An appropriate hedging vehicle is used to match that position as closely as possible (minimise basis risk).
A dynamic hedging strategy is applied when the attributes of the underlying risky position may change with time. Assuming it is desired to maintain the initial risky position, additional transaction costs will be required. A dynamic hedging strategy requires more time and monitoring efforts.
Example of Hedging
Let's take an example of a cereal company that needs corn for making its product. The prices of corns are volatile. The company may protect itself from increased corn prices by purchasing corn futures contracts.
Why is it essential to know Hedging?
Hedging is one of the most critical aspects of Risk Management, and understanding Hedging well would allow risk professionals to devise better risk management strategies.