Managing Risks by Hedging and Minimising the Impact of Losses

Contributed by: RVKS and Associates.

Reducing the ramifications of long-term risks by putting in place control mechanisms and covering investment risks through hedging are among key risk management strategies. In today’s volatile and dynamic world, risk becomes an unavoidable aspect of any business. It would never be possible to eliminate risk, but at best, its impact can be minimised.

Risk Factors

The risk factors can be internal to an organisation like high attrition or it can be external factors such as changes in consumer preferences or even geopolitical events that potentially trigger a host of consequential reactions. Here, the focus will be on the investment risk faced by a business.

Identifying Risks

Identifying risks and putting in place control mechanisms to reduce their impact is risk management, and the most prominent strategy is to cover investment risks through hedging. In simple words, hedging is an investment that offset the losses incurred in any other investment.

Process and Premise

One of the primary ways to hedge is by entering into a derivative contract. Derivative contracts derive value from underlying assets such as stocks, indices, commodities, or foreign currencies. Stock derivative mitigates the fall in prices of a stock and index derivative minimises the fall in prices of a stock that does not have a stock derivative. It is in the same way that commodity and currency derivatives eliminate the loss on account of volatility in the price of a commodity and foreign currency.

Benefits Galore

Some of the commonly used derivative contracts are forward contracts, options, futures, and swaps. Each of the contracts is operated by a specific set of rules. To enter into a hedging transaction, the hedger has to pay a premium or a margin to avail of benefits. When the predicted risk does not materialise, the premium or margin shall be a sunk cost to the hedger and further leading to a no-loss situation for the asset or liability held.

The key benefit of hedging is the ability to mitigate risks by safeguarding the value of the underlying loss situation to the asset or liability held. Secondly, hedging will limit losses and prevent it from ballooning when the price fluctuates. Further, it removes uncertainty in the future price of an underlying asset.

While the objective of hedging is to neutralise risk, speculation is to earn profit from the potential price fluctuation opportunities. The principal difference between hedging and speculation is that in the case of hedging, there is underlying exposure while in speculation that is not the case. Hedging transactions will be entered into by risk-averse people while speculations are entered into by risk lovers.

Written by Gopinath P – Partner at RVKS and Associates

Mr. Gopinath is a Partner with the Chennai Branch. He specializes in handling Corporate Insolvency Resolution Process, Liquidation Proceeding and Restructuring with more than 3 years of experience since inception of Insolvency and Bankruptcy Code.

He is actively involved in Direct Tax representations assisting clients in litigation matters till Appellate level and Refund collections. He has been advising clients on Corporate Insolvency Resolution Process & Liquidation Proceeding and representing cases before National Company Law Tribunal.

Contributed by:

R V K S and Associates

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