Hedged
By now you know our fascination with explaining word origins. Here's another one :)
Making a ‘hedge’, in farming, means growing bushes and trees around your crop field/garden to serve as windshields. They are used to protect the greenery of your garden.
Sometimes, our Banker-buddies also need to ‘hedge’ or protect the greenery in their bank accounts against turbulence.
Hedging is a method that protects a person from a possible loss or hardship from any known or unknown event that may occur. Humans are in general loss averse; so much so that sometimes we do irrational things in the name of protecting (or hedging) ourselves.
Let’s take an example of a certain event that most of us had first hand experience with during this lockdown.
On 24 March, 2020 the Government of India announced a 21-day lockdown. On hearing this news the first thing most people did was run with all they had to the nearest kirana or grocery store.
Why did all our local kirana shops get flooded with so many people?
People predicted that there would be a shortage of food items. So, in order to protect their families from a possible starvation following the lockdown, they flocked to the nearest kirana stores to buy and save whatever was available. They wanted to avoid any future hardship.
People also predicted an increase in the price of daily needs items (shortage in availability of necessities tends to push their prices higher). They would have to buy the same stuff later at a higher cost. To avoid this future loss and to save money, people purchased those items upfront at regular prices, and created a buffer.
We ‘hedged’ ourselves against the winds of a possible increase in price tomorrow and facing hardships, by buying more quantities (at current prices) and stocking-up for future demand today.
Thus, hedging is a tool for protecting against losses and reducing risks or hardships.
So what role does this tool have in the world of finance?
While hedging can involve complex mechanisms, we will keep it super simple.
Let us understand this using the example of the largest petroleum refining and marketing company in the country, Reliance (which uses oil as a raw material input).
Note that India does not have much natural oil reserves, and imports ~84% of its oil consumption. We are the third largest importer of oil in the world.
For Reliance, purchasing and importing oil is not a one time transaction, it involves multiple deals and agreements which are chalked out at different points in time throughout the year. And the price of oil keeps fluctuating (we recently saw it go below zero!)
In the current situation, when the demand is low and the oil prices have crashed, what would our forward-looking Mr. Ambani be thinking?
He would be thinking about the oil which he would require once the lock-down is over (future demand).
Demand for oil will be back again once vehicles hit the road, factories are reopened, and normalcy prevails. Everybody will want to buy oil. So, the prices of oil will increase (demand pull effect).
Smart as he is, Ambani thinks of a plan to avoid paying more when the world opens up.
He plans to hedge his oil purchase bills by entering into an agreement to buy oil after two months at a price which would be fixed today.
We call this a forward-contract. Enter into a contract today for Quantity X at Price Y of a commodity. Get it delivered at a future date.
The price fixed today will obviously be lower than the price he expects to pay later. Let us say he enters the contract at $10 per barrel.
Now, even if after two months the price of oil shoots up to $25 per barrel, Mr. Ambani would have to pay only $10 per barrel for those oil purchases. If the price (for some reason), goes down to $2 per barrel, he would lose $8 per barrel.
Thus, by hedging his purchase, he locked the price at $10. Come sunshine or rain, no one can change that price.
But, why would someone want to do that? Why would someone want to hedge if they could also end up losing because of it?
Simple answer - to reduce volatility, increase predictability, and ultimately, to reduce risk.
Finance folks think of risk in terms of volatility. Lower the volatility, higher the predictability, lower the risk of anything happening out of the blue. Reducing risk helps an organisation to focus on other more important parts of the business.
By hedging regular purchases of raw material (oil), Reliance ensured that it is not affected much by volatility in oil prices (be it profitable or loss-making). It protected itself from the winds of a changing oil price.
Peace of mind is paramount when you are hedged.
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