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When it comes to investment, hedging is not a strange word. Though many of you have already heard of the name hedging, not many of you may be able to explain what hedging is. Without the ability to explain the term, I guess you have not yet participated in the hedging world, which actually can be useful to protect yourself. Let us now understand it.

Why do you need a hedge? It is because every investment is linked to certain level of risk, a hedge is your insurance that helps you reduce the risks. The higher the risk, the more likely the investors or the companies will enter into hedging. Different types of hedging are available and the common ones are foreign currency swap, interest rate swap, futures hedging and hedging for stock price.

The core objective for hedging is to reduce the risk instead of earns money. Therefore, what you would do is to invest in two products that are negatively correlated. In simpler term, that is when investment A earns money, investment B will lose money. The gain and the loss offset each other that your risk is minimized.

It always makes sense that, the higher the risk, the high the opportunity. When the risk is reduced by hedging, you can expect the highest possible earning to be reduced, too. But on the other hand, as the risk is reduced, when you are losing money, the amount that you are going to lose can be lesser.

Let me give you an example on interest rate swap. If you have a loan from the bank of $100,000 and the bank is charging you a floating interest rate (or market rate). You biggest concern must the increase in interest rate (“interest rate risk”), which than you have to pay more interest. To reduce the interest rate risk, you can enter into an interest rate swap with the bank.

As mentioned, the hedge reduces your risk and at the same time reduces your possible earning. Depending on how much risk that you wish to reduce, you can enter into swap that amounts to exactly $100,000 or you can just enter one that is $50,000. Let us now assume you have entered into a $100,000 interest rate swap that you receive floating interest income.

When the market rate goes up, you have to pay more for the loan, but on the other hand, you receive more from the interest rate swap. On the other hand, if the interest rate goes down, you pay less, but you receive less as your interest income. To note that, hedging may not help you eliminate the risk but only reduce, therefore, you cannot expect that the interest pay out should be exactly the same as interest income.