Question

Discuss the principles of hedging and explain the risks associated with hedging.

Answer 1

Answer-

Principles of hedging

Hedging protects against the risk of high prices fluctuations and commodities hedging is done by using energy derivatives, which includes OTC Energy Swaps which is a financial instrument used for both speculation and hedging purposes.

Advantages of hedging are-

Hedging helps in generating consistent and stable cash flows
Hedging helps in determining a sale/purchase price of a commodity
Hedging helps in reducing the existing cash position risk exposure.

Hedge funds are very prominent in Finance industry. The following are the characteristics of hedge funds.

Hedge fund returns are stated on an absolute basis or on a relative basis.
Hedge funds are less regulated and are set up as a limited partnerships and the investors are limited liability partners.
Hedge funds are less liquid than traditional publicly traded investments and have restrictions on redemptions like lock up periods or notice periods.
A lockup period does not allow the withdrawals after the initial investment is made and a notice period which is 30 to 90 days of time after the request for redemption is fulfilled.  
Hedging by the managers often attract significant transaction costs when they redeem shares however the redemption fees can offset these transaction costs.

Risks associated with hedging

The performance and diversification of the hedging are problematic as there are different strategies used which are risky at times.

The hedge funds and hedging are having lesser correlations than the global equity market returns which provides lot of diversifaction benefits but the correlations tend to increase a lot during financial crisis which causes losses.

The hedging of currencies can lead to losses as they bet in one direction and the currency movement happens in other direction leading to losses for many firms which have global operations.

The redemptions increase when the performance of hedge funds decrease and costs of honoring redemptions may furter decrease the value of partnerships interests which increases risk.