Corporate Finance Module: Hedging of Funds, Benefits and Limitations

This report delves into the concept of hedging in finance, highlighting its benefits and limitations. It begins by defining hedging as a strategy to secure funds and minimize investment risks. The report explores the advantages of hedging, such as protecting investor profits, balancing portfolio returns, and serving as an effective risk management tool. It then discusses various hedging methods, including derivatives like future contracts, forward contracts, options, swaps, and warrants, as well as diversification strategies. The report also addresses the disadvantages of hedging, such as associated costs, potential profit limitations, and the complexity of the methods, especially for short-term investments or small investment amounts. The conclusion emphasizes the importance of hedging in protecting investor funds and mitigating market volatility while acknowledging the existing limitations.

Corporate Finance: Benefits and limitations of hedging

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
Table of Contents
Introduction................................................................................................................................3
Usefulness of understanding the concept of hedging.................................................................3
Benefits of hedging....................................................................................................................3
a) It protects the profit of the investor.................................................................................3
b) It balances the overall return on portfolio...................................................................3
c) Save the investors............................................................................................................4
d) Effective risk management strategy............................................................................4
Different types of hedging methods...........................................................................................4
(a) Derivatives...................................................................................................................4
i. Future contracts...........................................................................................................4
ii. Forward contracts....................................................................................................4
iii. Options.....................................................................................................................4
iv. Swaps.......................................................................................................................5
v. Warrants...................................................................................................................5
vi. Diversification.............................................................................................................5
Disadvantages or limitations of hedging strategies....................................................................5
(a) Fee or cost of hedging.................................................................................................5
(b) Reducing or limits the profit of the investors..............................................................5

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
(c) Not useful for short term traders.................................................................................5
(d) Not useful for small amount of investment.................................................................6
(e) Complicated methods of hedging................................................................................6
Conclusion..................................................................................................................................6
References..................................................................................................................................7

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
Specific purpose: To make my audience aware about the concept of hedging in finance
Central Idea: Concept, benefits and limitations of different methods of hedging
Introduction
I am going to introduce the topic ‘Hedging’. It is a strategy in finance by which the investor
can secure its fund and minimize the risk associated with return on an asset. In other words
hedging can be defined as an investment option by which the investor can protect its asset
from losses due to fluctuations in the market.
Usefulness of understanding the concept of hedging
However, there is always a certain amount of risk associated with any investment. Whether it
could be investment in Stocks, Commodities, currencies and mutual funds or it is any other
financial instrument. But by using the techniques of hedging, one can make a balance of
return in his investment portfolio by assuring minimum amount of return.
Benefits of hedging
a) It protects the profit of the investor
For example: By suing financial derivatives like ‘Options’, an investor can protect the profit
for their investment. Using ‘Put Option’, investor may receive a right to sell the stock at a
particular price within a particular time period. This strategy helps the investor by protecting
his return in volatile market (CFI, 2020).
b) It balances the overall return on portfolio
For example: Diversification is also a hedging strategy used by many investors to balance
the return on their portfolio. It focuses over not to invest all the money in only one asset. Like
if an investor is investing some of its asset in stocks then it should invest half of its money in
corporate bonds or fixed deposits. In case the stocks prices fall down, then the fixed and
assured return over corporate bonds or fixed deposit will save the whole portfolio of the
investor (CFI, 2020).

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
c) Save the investors
It saves the customers from fluctuations in the investment management due to various types
of risk associated with every investment (BJ Henderson, 2020). It makes the investor
comfortable in terms of getting a particular amount of return.
d) Effective risk management strategy
Hedging is a very effective risk management strategy which makes the investor secure in
terms of return on his investment (CFI, 2020). It ensures the investors for receiving a
particular amount of return over his investment in the worst condition of market (Wolfe,
2020).
Different types of hedging methods
(a) Derivatives
A derivative is a pre fixed and well defined contract between two or more parties, in which
the value of the underlying assets is derived from the contract. These underlying assets are
stocks, commodities, currencies, market index and value of bonds (CFI, 2020).
Various types of derivatives are as follows:
i. Future contracts
Future contracts are the legal agreement between buyers and sellers to sell or buy a particular
quantity of stock or commodity at a prefixed price at a prefixed date in future.
For example: One investor buy a future contract of purchasing 1000 barrel of crude oil from
the seller in the next month at a particular price and at a particular date (CFI, 2020).
ii. Forward contracts
This a kind of private agreement between two parties which makes the buyer to purchase the
particular asset at set price and obliged the seller to sell the particular asset at a prefixed date
at a set price (answers, 2020).
iii. Options

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
Option is also a type of contract between buyer and seller which gives rights but not the
obligation to the option holder to purchase or sell a particular asset at a prefixed price at an
agreed date in future (CFI, 2020).
iv. Swaps
A swap is a derivative contract between buyer and seller by which two parties can exchange
their cash flows from two different financial investments (V Pandit, 2020).
v. Warrants
It is a contract used to deal with securities which gives the investor a rights but not
obligations to purchase certain number of stocks at an agreed price before a certain time (MA
Naeem, 2020).
vi. Diversification
It is also a risk management strategy of hedging in which by investing different types of
assets, an investor can balance the return over his portfolio. If some of the proportion of fund
is going to invest in risky assets then another proportion of the asset should be invested in
risk free asset so that the investor may get a particular amount of assured return against his
investment (CFI, 2020).
Disadvantages or limitations of hedging strategies
(a) Fee or cost of hedging
Hedging is taking a significant amount of cost to protect the fund which has to be faced by
the investors and that is why it minimizes the profit of the investor (CFI, 2020).
(b) Reducing or limits the profit of the investors
Risk and return are usually parallel to each other. At the one side if hedging reduces the risk
of loss, on the other side it also limits the profit of the investors (BJ Henderson, 2020).
(c) Not useful for short term traders
Hedging is not very useful for short term investments. It is useful only in long term investors
because usually the hedging technique takes one month to be exercised (mandi, 2020).

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
(d) Not useful for small amount of investment
Hedging with the help of options and future contracts, a significant amount of investment is
required. That is why hedging technique is not useful for those investors who are investing a
little amount of investment.
(e) Complicated methods of hedging
Methods of hedging require a lot of technical skills and understandings. That is why before
adopting the hedging strategies one should equipped with sufficient technical skills of finance
so that he can properly understand the terms and conditions of risk management strategies
(mandi, 2020).
Conclusion
On the bases of above analysis, it can be concluded that hedging is very beneficial for the
investors because it protects them from loss and secure their return on investment. It not only
helps the investors by saving their funds but also make the investors ensures about receiving
a certain amount of profit for their investment even in worst position of financial market.
Despite of a lot of benefits of hedging the funds, there are a little bit limitations exists for
adopting the various types of risk management strategies. Still it is very clear that hedging is
very effective method to protect the funds of investor and save him from the volatile market
conditions.

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HEDGING OF FUNDS: BENEFITS AND LIMITATIONS
References
answers, I. (2020, March 22). Forward Contract. Retrieved from The official website of
investing answers: https://investinganswers.com/dictionary/f/forward-contract
BJ Henderson, N. P. (2020). Pre-trade hedging: Evidence from the issuance of retail
structured products. Journal of Financial Economics.
CFI. (2020, March 22). Derivatives: Financial contracts whose value is linked to the value of
an underlying asset. Retrieved from The official website of Corporate finance
institute: https://corporatefinanceinstitute.com/resources/knowledge/trading-
investing/derivatives/
MA Naeem, S. F. (2020). Hedging the downside risk of commodities through
cryptocurrencies. Applied Economics Letters, 1-8.
mandi, a. (2020, March 22). What Is Hedging? Advantages And Disadvantages. Retrieved
from The website of advisorymandi: http://www.advisorymandi.com/blog/what-is-
hedging-advantages-and-disadvantages/
V Pandit, M. M. (2020). Hedging Techniques using Derivative Instruments. Our Heritage,
329-343.
Wolfe, M. (2020, March 22). Advantages and Disadvantages of Hedging in Finance.
Retrieved from The official websie of pocketsense:
https://pocketsense.com/advantages-disadvantages-hedging-finance-2246.html