In the business world, an element of risk lingers behind almost every choice we make. Whether buying a parcel of oceanfront land or planting corn instead of wheat, there are no guarantees that our decisions will be good ones. Risk is present in everything we do, and hedging with futures helps put the “worst-case scenario” into manageable terms.
Aside from avoiding the pitfalls of excessive leverage and having a sound plan, futures can help mitigate the negative impacts of the unfortunate. Through hedging with futures, checking risk becomes routine.
What Is Financial Risk?
Financial risk is a major concern for business people and investors alike. It frequently destroys wealth and may undermine an otherwise effective marketing strategy. Nonetheless, there’s good news: Hedging with futures can greatly reduce exposure to financial risk.
Financial risk comes in many forms, each dangerous in its own way:
|Type of Risk||Definition and Impact|
|Systemic||Systemic risk addresses the relative stability of the broader financial system. In the event systemic risk reaches dangerous levels, sudden crashes in equity, currency, or commodity markets become increasingly possible.|
|Liquidity||Liquidity risk refers to the inconvertibility of assets to cash (or vice versa) to limit losses in periods of extreme pricing volatility. This type of risk is common to producers because finished products or commodities may not be readily sold to meet obligations.|
|Currency||Currency risk is specific to investors in foreign monies or assets. In the event fundamental factors negatively influence the exchange rate of the related currency, the value of the holdings decrease. Currency risk is a major consideration for portfolios that hold international assets.|
|Credit||If you’ve heard the term “bankruptcy” — or gone through one — then you’re familiar with credit risk. This type of risk involves an entity not being able to satisfy or restructure debt obligations. Credit risk can prompt a variety of unfortunate events, such as corporate takeovers, asset liquidations, and investor loss.|
It’s a hard truth, but business is not conducted in a vacuum. One or all of the risks above may intervene and negatively impact an investment or venture. However, by implementing various hedging strategies, it’s possible to limit the financial damage.
Hedging with Futures Puts Financial Risk in Its Place
Hedging strategies come in all shapes and sizes, from advanced to basic. Below are a few ways that business people from all walks of life use futures to save money when the unexpected strikes:
|Type of Risk||Futures Hedging Strategy|
|Systemic||To protect against a broad-based market meltdown, investors or producers frequently buy gold futures. Other safe-haven futures contracts, such as silver or the Swiss franc FX, are also used to insulate against systemic failure.|
|Liquidity||One of the premier advantages to futures products is their inherent liquidity. Assume that a person is heavily invested in a mutual fund, ETF, or real estate. Converting the position to cash may be an involved process, including fees and considerable time to execute. By taking either a long or short futures position related to the portfolio’s base asset(s), losses due to transactions costs and adverse swings in asset pricing may be effectively limited.|
|Currency||Implementing a “buy and hold” strategy using foreign currencies is a popular means of investment. In order to reduce the chance of the purchase losing significant value, offsetting positions may be taken in one or more correlated FX currency futures.|
|Credit||Credit risk is a challenge to hedge against, due to its locality. An entity may be in financial distress without showing any signs of trouble before going bankrupt quickly. One way that investors hedge against credit risk is by buying S&P 500 Volatility Index (VIX) futures. During times of extreme market volatility, such as in 1987 or 2008, the VIX rises, as does the chance of corporate insolvency. In these instances, holding long positions in VIX futures can help to limit losses due to credit default.|
Saving Money Is the Name of the Game
No one wins 100% of the time. In order to succeed in the long-run, it’s imperative to minimize losses. Hedging with futures gives business people of all types a way to avoid catastrophe and ensure the best odds of success.
A great resource for all things hedging is Daniels Trading’s online hedge portal. Featuring the DanielsAg mobile app and expert market analysis, it has everything you need to tackle the risks facing your business.