Hedging: Necessity or Futility?
When I was a kid my father shared with me a newspaper article on investment. The article contained all the mathematics showing the amount of investment required for earning a certain pension some few years later, adjusted for the projected inflation. This cumbersome mathematics was nothing else but a retirement plan. At the time I was too young to understand this, but now I really understand how important it is to plan for the future. But in these volatile times, securing only for the future with just a retirement plan will not suffice. Hence, we see a new cumbersome mathematics gaining momentum, and that is hedging.
Hedging in a way is similar to a retirement plan; it is all about protecting your future position by a shrewd investment. Hedging is a technique designed to reduce or eliminate financial risk. While Barron’s law dictionary defines ‘hedging’ as a concept that involves offsetting a risk position, Britannica says that it is about reducing the risk of loss caused by price fluctuation. In a nutshell, hedging is all about determining the risk, evaluating it, and protecting against it. Retirement is a risk, it is the time of life when earnings dry up, so saving for retirement today is actually hedging for it.
The big question is whether hedging is important to us? The answer is definitely yes. If there is a risk, it should be countered by hedging. Talking of the risks we face, they are everywhere! Each passing moment is rife with risk; the computer you are using may overheat and burn, the chair you are sitting on may break causing a spasm in the back, your building may collapse due to an earthquake, your daily metro may derail, your car may get struck by a drunken driver, or more severely you may get an electric shock in the bathroom on a wet floor! I don’t want to terrify you but the reality is that risks are everywhere!
Humans are hardwired to hedge naturally; do you remember the reflex action that was automatically generated when you touched the hot electric iron accidently? Yes you do. It is fun to say ‘an apple a day keeps the doctor away’, but eating it hedges the potential diseases. Speaking of intended hedging, we safeguard ourselves by selecting the right company to work for, right business partners to work with, right friends to spend & enjoy time, and most importantly, the right life partners to spend your life with.
Some risks can be quantified and some cannot, so this write-up focuses on quantifiable financial risks. As life progresses, from childhood to senility, we also experience adolescence and adulthood. Our priorities keep changing and so does the money allocated on them. Sometimes we know where all we need to spend money and sometimes an event may just occur which drains us to the pit.
The critical step is to identify these situations (or technically ‘exposures’) that can put one in jeopardy in the coming future. The key would be to jot down the areas where expense is possible in the future, i.e. by making a list of out of pocket expense activities. For example: outlay for medical treatment, house repairs, education, car repairs, household equipment maintenance, kid’s education, and expense while on vacations. It’s similar to budgeting for the time ahead. For some activities cost is certain and known to an approximate amount, for this risk is minimum or nil. But for some the cost is not certain and can vary staggeringly, and therefore risk is also immense. For making the list, tools such as Microsoft excel, Google Docs, Calc (openoffice.org), or Zoho sheet would come in very handy. It should be as exhaustive as possible, you may take time to ponder and include more exposures which one may deem necessary. Ideally budgeting should cover a time span of at least 5 years.
Next step is highlighting the areas of maximum risk (or uncertain costs) or the ones which exceed the limit of your comfort spending (highlight these with red, as it grabs attention to these areas). This will give an idea about how much vulnerability (or ‘exposure’) is most likely to happen. Chances of it occurring may not be cent percent, but if the event happens you should be either ready to spend or must have hedged in advance by paying a premium to cover the likelihood of occurrence. If the event occurs the only sum to be paid is already paid in advance, and if it doesn’t the maximum loss is that paid premium which is a fraction of the amount of the hazard.
For example, if you want to save for education, the amount is known with a level of certainty as macroeconomic dynamics like inflation rate may or may not change much keeping the price in limits. But for an accident one cannot foretell the costs in advance and depending on the severity, the costs would vary. The approximate limits of education expense are known to a certain confidence level, and hence the risk is also minimum as compared to the cost for a probable accident. Risk is about how much the cost would vary, if uncertainty is more the risk is more and vice versa. If the risk is more, it does call for attention and involvement of hedging as you wouldn’t want to end up spending years of savings on one particular unanticipated event.
After the actionable risks have been identified, precautionary measures have to be taken. For most situations, precautionary deals available are insurance, annual maintenance contracts and investments promising certain yields in a timeframe. Insurance in most general terms is a mutually agreed arrangement amongst members of a community where each one contributes a little; the sum is used in case of conjuncture of a member. The presumption is that not all members would be in distress at the same time. Annual maintenance contracts reduce the cost of forecasted repairs by promising certain business to the vendor. Some investment plans are fixed deposits, recurring deposits, and investment schemes by Life Corporation of India, and so on.
The key take away is to keep your eyes & mind open and to think far ahead; if there is a possibility of risk which can be hedged or protected by incurring minor price it should be taken, as we all know a stitch in time, saves nine. Play safe, indulge in hedging!
About the Author:
Saurabh Hasija, a PGDM student at IIM Ranchi, pursued his summer internship from IBMC Financial Professionals Group in Dubai. He also has an experience of over 3 years in the field of ‘Bid Management & Handling’ at Nokia Siemens Networks Pvt. Ltd.