What is Hedging?
Hedging or hedge accounting is a risk-mitigation technique used to protect the current financial position from potential losses. Hedging is often confused with speculating. The major difference between the two is that hedging does not involve guessing, whereas speculation is based on guessing the direction of movement of the underlying asset to book profits.
Areas where Hedging can be used
Hedging can be used to mitigate risk in the following areas:
- Securities market: The securities market is commonly known as the share market or the stock exchange. This market is used by individuals and firms to purchase and sell securities that are listed on the stock exchange. Such securities are highly liquid and involve digital trading.
- Commodities market: This market includes the investments made in precious metals such as gold and silver, energy products like crude oil and natural gas, and other base metals like copper and aluminum. The associated risk is called commodities risk.
- Interest rate swaps: Two counterparties enter into an interest rate swap when one pays a fixed rate of interest and the other pays a floating rate of interest. This hedging in interest rates helps in mitigating risks related to fluctuating interest rates.
- Currencies: The currency market comprises a plethora of exchange-traded foreign currencies. Many risks are associated with currency trading, like volatility and currency exchange rate risk. Hedging is done in currencies by taking a position in one currency vis a vis another to reduce the risk of the currency exchange rate.
Types of Hedging
Hedging takes place with the help of derivative contracts. These contracts draw values from underlying assets such as stocks, currency, market indices, interest rates, or commodities. Derivative contracts have an underlying asset, counterparties with long or short positions, and an expiration or maturity date as their major components. Hedging can be done using a combination of derivative products like forward contracts, futures contracts, swaps, and options.
Hedging strategies can be classified into the following types:
- Hedging through asset allocation: Asset allocation means investing in several asset classes to reduce the risk by spreading it. Hedging through asset allocation is done by diversifying an investor's portfolio through various classes of financial assets.
- Hedging through structures: Structuring a portfolio means assigning the proportion of investment between debt instruments and stable asset classes.
- Hedging through options: Call and put are two types of options. An option holder has the right, but he is not obligated to buy or sell the option contract.
Benefits of Hedging
Hedge funds are an important part of alternative investments and have both pros and cons.
Following are some benefits of hedging:
- Hedging helps the investor invest in various asset classes rather than investing in traditional, fixed income bearing securities.
- Hedging encourages asset allocation, thereby spreading the risk associated with the portfolio across different asset classes. Reducing overall risk helps the investor book a higher profit margin than what he would have earned without hedging.
- Hedge funds have lesser legal and regulatory requirements in comparison to some other investment classes. It helps the investor easily enter into a hedging contract. Also, hedge funds allow the investor to make liberal use of short positions and leverage while investing in a hedge contract. Such flexibility is not easily possible in other investment classes.
Disadvantages of Hedging
- Hedging involves cost in the form of a derivative premium to be paid along with the additional cost of carrying and delivering the underlying asset on the expiration of the contract. This makes it is a costly process and reduces the amount of profit earned.
- Hedging helps in reducing the risk of the portfolio. Since profits increase with an increase in risk, hedging ends up reducing the profits.
- Hedging is a time-consuming process. So, it is not suitable for traders such as intraday traders.
Understanding macro hedging
Macroeconomic factors can change the entire economy. They can affect the whole portfolio of investments, not just the single security of the portfolio. For example, any fluctuations in inflation may have an adverse impact on the economy, along with investment portfolios. Hedging in these factors to reduce the risk of the portfolio is called macro hedging.
Macro hedging vs micro hedging
Hedging strategies that help eliminate or reduce the risk of the entire portfolio that is responsive to factors affecting the national economy are called macro hedging. On the other hand, micro hedging assesses and tries to eliminate risk for a single asset or security of a portfolio.
Working mechanism of macro hedging
Portfolio managers involved in macro hedging have access to sophisticated trading platforms and the knack to build a profitable portfolio by using a diverse class of assets and hedging strategies. Sometimes, it is easy to recognize trends in macroeconomic factors and forecast results, but this happens only in rare cases. At other times, it is necessary to have in-depth knowledge about the market to take advantage of the hedging position.
Macro hedging exchange-traded funds strategies
Macro hedging ETF techniques make use of inverse stock positions. When investors can book profits even when the markets are moving adversely, it is called an inverse ETF position. This was seen most recently during Brexit. Brexit brought about a devaluation of the British currency and short-term losses in several stocks in the UK markets. Investors who could book profits from Britain's exit from the European Union had hedged their risk in GBP by taking a contrary position in related stocks.
Alternative hedging strategies
Using derivatives creates an additional risk of capital loss for a portfolio because this technique requires the added cost of purchasing a product that takes a position on an underlying asset. Leverage is often used, which requires the investment to outperform its rate of borrowing.
Successful implementation of macro hedging
Macro hedging can be utilized to offset a part of a portfolio that is likely to react to a macro projection. It involves a contrary position in a related asset entered into by the investor on portions of a portfolio. It can also include outweighing the securities expected to perform.
Institutional macro hedging
Asset managers like BlackRock and JP Morgan are the top-performing portfolio managers in macro hedging portfolio solutions for institutional clients.
Challenges in macro hedging
When financial institutions like banks decide to use macro hedge accounting, several requirements need to be met on a daily basis. A couple of challenges faced by financial institutions, specifically banks, in adopting a macro hedging strategy are mentioned below:
- Macro hedging is a time- and capital-intensive technique. It involves a lot of capital expenditure as the entire work process is automated. This automation of the work process also takes a lot of time. So, it may not be possible for all the financial institutions to adopt this process because they may not have the required capital for implementation.
Discussion paper on accounting for macro hedging
Most financial institutions manage risks for the entire portfolio rather than for each contract individually. Dynamic risk management is an ongoing process because the risks that such companies face, change over a period of time, as do their techniques for mitigating risks. The provisions laid down under IAS 39 are outdated as they have not been modified for a long time. Owing to this, recording transactions related to macro hedging becomes difficult and ambiguous.
IFRS 9 vs IAS 39
The IASB replaced IAS 39 with IFRS 9 on financial instruments in 2014. However, the IASB treats the macro hedging component as a separate project. This stage is called Portfolio Revaluation Approach (PRA). Under PRA, the following points need to be considered:
- Investments that have dynamic risk management should be revalued for any changes in the managed risk, and any profit or loss should be recorded.
- Changes in fair value arising from derivatives used to mitigate the risks associated with these instruments should also be recognized as profit or loss.
- Investments that use dynamic risk management techniques do not need to have their fair value recorded.
Students often mistake macro hedging with micro hedging. A macro hedging strategy is used to eliminate the risk of a portfolio arising due to a change in any macroeconomic factor. These factors can be inflationary trends, gross domestic production expectation, etc. Micro hedging strategy is used to eliminate risk in any one item of the portfolio as opposed to eliminating the risk of the entire portfolio.
Context and Applications
This topic is significant for graduate and professional exams, especially:
Master of Business Administration (Finance)
Bachelor of Business Administration (Finance)
Bachelor of Commerce
Master of Commerce
Q1: Identify the risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
(b) Micro hedging
(c) Macro hedging
(d) Call option
Correct option: (a)
Explanation: The given definition best suits "hedging". Micro hedging involves reducing risk via large assets while macro hedging includes the elimination of risk when there are macro-economic changes. The call option is an option to buy the security at a particular price.
Q2: Identify the area where hedging can be used.
(a) Purchasing a fixed asset
(b) Purchasing a share or equity
(c) Purchasing a debenture
(d) Purchasing a preferred stock
Correct option: (b)
Explanation: Hedging can be used in shares or equity only because it involves mitigating the risk of the portfolio consisting of equity.
Q3: Identify the process of investing a certain portion of the portfolio in debt instruments and the rest in stable asset classes.
(a) Allocation through assets
(b) Allocation through options
(c) Allocation through structures
(d) Allocation through diversification
Correct option: (c)
Explanation: Allocation through structures involves allocating a specific portion towards debt and remaining in large-cap stocks or deposits.
Q4: Identify the process of risk mitigation around events like inflation, unemployment, national income, gross domestic product, etc.
(a) Macro hedging
(c) Micro hedging
(d) Social factors
Correct option: (a)
Macro hedging involves mitigating risk around macroeconomic events. Hedging is used to offset losses in investments by taking an opposite position in a related asset. Micro hedging involves reducing risk via large assets.
Q5: Identify the accounting or financial reporting standard to which accounting-for-macro hedging is now aligned.
(a) IAS 39
(b) IAS 9
(c) IFRS 9
(d) IFRS 39
Correct option: (c)
Explanation: IFRS 9 deals with macro hedging. IFRS 39 deals with the recognition and measurement of financial assets. IAS 9 and IAS 39 do not deal with macro hedging.
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