Criticism on Hedging

Siraj Mir
2005-1-53-5336
Hedging
What is Hedging ?
• In finance, method of reducing the risk of loss caused
by price fluctuation. It consists of the purchase or sale
of equal quantities of the same or very similar
commodities, approximately simultaneously, in two
different markets with the expectation that a future
change in price in one market (spot) will be offset by
an opposite change in the other market (futures).

There are many specific financial vehicles to

accomplish this:
• Insurance policies
• Forward contracts
• Swaps
• Options
• Many types of over-the-counter and derivative
products
• Most popularly, futures contracts
Criticism on Hedging
Disadvantages of Hedging
• Hedging involves cost that can eat up the
profit.
• Risk and reward are often proportional to one
other; thus reducing risk means reducing
profits.
• For most short-term traders, e.g.: for a day
trader, hedging is a difficult strategy to follow.
• If the market is performing well then hedging
offers little or no benefits.
• Trading of options or futures often demand
higher account requirements like more capital
or balance (margin).
• Hedging is a precise trading strategy and
successful hedging requires good trading skills
and experience.
Example
• President: This is terrible. We have lost $3 million in the
futures market.

• Treasurer: The purpose was to mitigate risk…don’t forget

we made $3 million from oil price increase to offset the loss
in futures market….

• President: What ? That’s like saying we do not need to

worry when our sales in California is down because it went
up in New York .. The overall profit went down!

• Treasurer: Had the oil prices gone down..?

• President: I don’t care if they had, the fact is that they have
gone up and we have lost profit and I will have to explain to
the share holders that your actions reduced our profits by $3
Million and this means no Bonus for you this year

• Treasurer: That’s unfair…

• President: Unfair ? You are lucky not to be fired!

Hedging
• Share Holders vs. The Management

Conclusion
• The purpose of hedging is not to
make money but to protect oneself
from incurring losses.

• So that means, Hedging is only a

viable and a logical decision when
one expects to incur a loss!