Advantages and Disadvantages of Hedging in Finance

Most of the companies use hedges to reduce the risk level in their most important areas of operation, which is very beneficial for the companies during very volatile market conditions which would otherwise be detrimental to the profits of the company. While making huge investments considering the hedge investment is favorable as it is more or less like an insurance policy to protect against the market risk of fluctuating conditions and protecting the investor form steep losses.

Why Hedging is considered

Since companies have exposure to markets suiting their area of operation, securing the cost of any cost fluctuations help in managing the production cost to be in control. For example, Airline industries have huge requirement for fuel which is often hedge to keep them unaffected by the pricing variations in energy-related costs.

Similarly, hedging can be resorted to locking in the price of commodities to be used future for fixing their production costs, in case the price goes down it protects them from the pricing decline, and in case of rising values, it is often set off by commodity price declines. If companies stayed away from the hedge it, had a tough time to accommodate the rising costs to keep them in operation.

Advantages

  • risk on the investment is considerably reduced very significantly
  • losses can be offset if they use hedging as an advantage for the cost which is highly volatile in the manufacturing and financial sectors
  • investment in the forex currency markets are definitely fluctuating which is saved by hedging in the international to a great extent
  • the positive or negative growth is forgone for a currency during the hedging due to the currency’s strength or weakness
  • higher returns, low relation with the correlated investment products
  • using time-tested strategies may not work and innovative techniques could be used in favor of the investors
  • easy liquidation process makes the investment in hedge funds to be simpler

Disadvantages

  • investing all the capital amount in hedging of a particular product may not be the best idea as funds have to be diversified in different funds,
  • redemption of funds invested in hedging could be difficult as they may stipulate a particular date and time for redemption and with a frequency which could be after 3 months
  • the cost of hedge funds is high, no so is the fees associated with it, which is two way, one is as good as administration fees charged while investing in Mutual funds, the other being according to their performance a percentage of profits is charged.