Hedging is a mechanism to reduce the risk of adverse price movements of an asset. It’s an investment undertaken to reduce the risk of adverse movements of the underlying assets. We all agree with the fact that in investment risks and returns are the two sides of a coin.  The underlying asset can be a security, currency, debt instruments or a commodity like crude oil.

A Perfect Hedge is an offsetting investment which completely eliminates the risk of the price movements. However, this is practically not possible, as all investments do carry a risk.

Hedging is accomplished by using futures contract whose underlying asset is same as the asset. The investor needs to take two positions simultaneously. Suppose if the investor has a commodity to sell in next 3 months then he needs to buy a future contract of similar value to offset the price risk arising until the time the commodity is sold. Similarly, if the investor is expecting a commodity to come in future, then he needs to buy the futures contract to hedge his/her position.

While an investor or corporation may account the gain or loss on the deal in the future, however the techniques employed by various regulators across the world call for decent margins on part of the buyer as well as seller.   The settlements of futures account take place daily. Therefore the profit or loss can be estimates on regular basis.

This is known as Mark to Market accounting. An investor can offset his or her position before the expiry of the futures contract.Hedging is mainly undertaken by exporters, importers banks and large corporations. Recently many derivative products have been designed to hedge the risk of adverse price movements.

These are Interest rate Derivative which has the bonds as underlying asset. While hedging one must remember that opposite movements of price should also cover the relevant brokerage and taxes as applicable.

There is no doubt that hedging can be the best mechanism which reduces the risk factor of the investment. The basic knowledge of various hedging strategies can be helpful to create awareness among the investors, helpful in understanding the market and helps to become a better investor.