Hedging is an increasingly popular terms in the investment markets. Though not many people actually enter into hedging, most of them have already heard of the term. In fact, to protect yourself, you should at least have the very basic knowledge of hedging. Therefore, let us now know more about hedging and a way to better protect you from risks.

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.

When the risk is higher, the earning or opportunity is likely to be higher, too. But, by hedging, the risk is reduced, therefore, the highest possible earning is also reduced. That means, when you are gaining on investment A, the gain is reduced by the loss in investment B. On the other hand, if you are making loss on investment A, the loss is reduced by gain in investment B.

To illustrate more clearly, we can now assume a case with interest rate swap. Assume that you have borrowed a $60,000 loan from a bank. No doubt, the bank will charge you interest say at LIBOR + 2%. As an interest payer, you must be concerned that the interest rate may increase. Therefore, you enter into an interest rate swap with the bank to receive a floating interest income at LIBOR + 2%.

When it comes to such hedging instrument, you have a choice to decide if you want to fully hedge or partly hedge. You can enter into a $30,000 hedge or a full hedge of $60,000. Why you want to do so? It is because there is tradeoff between you risks and opportunities. For simple explanation, I assume you have entered into a $60,000 hedge that you receive interest income.

When the interest rate increases, you have to pay more interest for your loan, but you receive more interest income on the other hand. If interest rate decreases, you can pay less interest for your loan, but your interest income also decreases. For explanation, hedging can be simple. But in real case, you may not find the hedging is such a perfect hedge that all your risks can be completely eliminated.

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