Hedging is a method that in practice to reduce the risk of loss caused by the price fluctuation. It consists of the purchase or sale of equal quantities of the same or very similar commodities in two different markets at approximately the same time, with the expectation that a future change in price in one market will be offset by an opposite change in the other market. Basically Hedging is a risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, Hedging is a transfer of risk without buying insurance policies. Hedging is also common in the securities and foreign-exchange markets.
Advantages of Hedging
1. Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
2. Hedging tools can also be used for locking the profit.
3. Hedging enables traders to survive hard market periods.
4. Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
5. Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
6. Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.
Disadvantages of Hedging
1. Hedging involves cost that can eat up the profit.
2. Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
3. For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
4. If the market is performing well or moving sidewise, then hedging offer little benefits.
5. Trading of options or futures often demand higher account requirements like more capital or balance.
6. Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.
Hedging is a familiar house hold term in Sri Lanka for quite a some time now. The Ceylon Petroleum Corporation entered into a hedging agreement with five local and international banks to buy crude oil at a capped price of $130 per barrel. The deal went sour when the oil prices fell below US$ 50 in the world market and CPC stood to lose nearly US$ 500 million. Supreme Court intervened and in November 2008 the Court ordered the CPC to suspend the controversial hedge payments to banks until a Central Bank probe into the matter is over.
The three foreign banks, CITI Bank, Standard Chartered Bank and Deutsche Bank sought redress with the arbitration panel in Singapore and Commercial High Court in London. Case ended CPC losing a $60 million hedging case against Deutsche Bank after a U.S.-based arbitrator ruled in favor of the bank.
References
Times Online: Sri Lanka's CPC loses $60
mln hedging case vs Deutsche Bank http://www.sundaytimes.lk/index.php?option=com_content&view=article&id=26390:sri-lankas-upr-sessions-open-in-un-geneva&catid=1:latest-news&Itemid=547
Sri Lanka prepares to challenge the
ruling on hedging case against Deutsche Bank http://www.colombopage.com/archive_12A/Nov04_1352007696CH.php
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