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Types of Hedging

IndianMoney.com Research Team | Updated On Tuesday, September 23,2014, 12:40 PM
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Types of Hedging

The instance mentioned above is a "classic" sort of hedge, known in the industry as a "pair’s trade" due to the trading on a pair of interrelated securities. As investors became more refined, along with the mathematical tools used to calculate values, known as models, the types of hedges have increased to a great extent.

Natural hedges

Many hedges do not involve foreign financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by corresponding cash flows, i.e. revenues and expenses. For an illustration, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and selects to open a production facility in that market to match its anticipated sales revenue to its cost structure. Another illustration is a company that opens an ancillary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more costly than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.

In the same way, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a diverse currency; it would be applying a natural hedge if it approved to, for instance, pay bonuses to employees in U.S. dollars.

One of the traditional means of hedging against risk is the purchase of insurance to shield against financial loss due to accidental property damage or loss, personal injury, or loss of life.

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