Investment Strategies of Hedge Funds

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Investment Strategies of Hedge Funds

June 3rd, 2010 · Dallas TX, USA -

Hedge is a investment strategy by which one can enter in an offsetting trade to minimize the risk arising due to market volatility.

Hedge is a term quite often used in the stock markets. Risk as we all know is the uncertainty of an outcome and to reduce the impact of any negative outcome we hedge. We all must have heard of insurance and may have bought one or two. Why do we buy insurance? Because, we are not sure what would happen in the near future thus, by buying insurance we are making sure that the anticipated loss would be minimized. Remember, we cannot stop the future events from occurring.

Stock market as we all know is very volatile and it is very difficult to predict the future movements of the stocks. Of course, we do forecasting however, that does not guarantee a prediction. If you own a stock and are thinking that the in future the prices are going to go down. What would you do? Sell them? If you sell them you will end up making loss. You should think of minimizing the loss by the fall in the stock price. You can minimize the loss by buying a put option (right to sell) on the stock. The put option gives you the right to sell the penny stock if the stock price falls below a particular price (called strike price).

Similarly, if a company is depended on a certain commodity for its production and fears that the price of the commodity is going to increase in future, it can reduce the loss of such outcome by getting into forward or future contracts. By doing so the company would be able to purchase the commodity at a set price at a future date. This would reduce the fear of fluctuating commodity price.
Hedging in the financial markets is complicated and requires a good understanding of the derivatives instruments. Most widely used derivatives are options, futures and forwards. One can hedge against risks arising due to change in interest rate, commodity prices, stock prices, currency exchange rate fluctuation, credit risks and even weather changes. For a fund manager portfolio protection is as important as portfolio appreciation.

Although one might think that hedging would help in increasing the profits without any risk involved, the truth is, one should do the tradeoff between risk and return as lower risk means lower return. Hedging comes at a cost. The cost is the price of the derivative and the amount by which profits were reduced in the transaction. Hedging involves huge amount of money and so retail investors would like to hold on to their stock till the market bounces back. The active players in hedge are Institutional investors and the big fund houses which manages huge sum of money. Nonetheless, one should understand the use of hedging as risk minimization strategy.

Tags: Investment