Interest Rate Swap

When the LIBOR increases, the bank will charge you higher interest on the $60,000 loan. This higher interest pay out can be offset by the higher interest income from the interest rate swap. Or, if the LIBOR decreases, the bank will charge you less for interest. But, you will also have lesser interest income from the interest rate swap. For this simple case, you may notice that the hedge is perfect as all the risks are totally offset. But in reality, it is seldom the case. You may still have a little bit gain or a little loss.

Always assess the risk before entering into new investments. Hedging reducing the risk at the same time reduces the potential return. Do according to your own risk preference.

Hedging and Interest Rate

No doubt, the bank will charge you interest say at LIBOR + 2%. As an interest payer, you must be concerned that the interest rate may increase. Therefore, you enter into an interest rate swap with the bank to receive a floating interest income at LIBOR + 2%.

When it comes to such hedging instrument, you have a choice to decide if you want to fully hedge or partly hedge. You can enter into a $30,000 hedge or a full hedge of $60,000. Why you want to do so? It is because there is tradeoff between you risks and opportunities. For simple explanation, I assume you have entered into a $60,000 hedge that you receive interest income.

Example of Hedging

As you see from the case of investment A and B, you will know that the risk of losing money from investment B is hedged by the gain in investment A. On the other hand, you can think that the gain in investment A is unluckily reduced by the loss in investment B. It is true that the possible earning from the total investment portfolio can be lower is the risk is hedged. It makes sense as the lower the risk, the lower should be the opportunity and earning.

To illustrate more clearly, we can now assume a case with interest rate swap. Assume that you have borrowed a $60,000 loan from a bank

Types of Hedging

There are many different types of hedging products available to cover different types of investments. You can find foreign currency ones, interest rate ones, future ones, options ones and stock price ones.

You have to remember the golden rule that hedging is not a way to help you earn more money. It is a tool to help you reduce the risk. By that, you will invest in two different products that are negatively correlated. The risk is reduced by the offset between the gain and the loss from each of the investment. Or, when investment A is in a gain position, investment is on the contrary a loss position. The gain offsets the loss.

Reducing Investment Risks

There are many ways to reduce your investment risks like research and analysis. But if you have a risky investment on hand, research and analysis may not be that helpful, you may need something more practical such as hedging. Hedging is a very powerful tool to reduce risk and is using by many different investors and well established enterprises. Let us begin to understand more about hedging.

Why there are so many people and well established enterprises use hedging? You need opportunities from investments. But no free lunch, there are risks linked to such investments. To reduce the risks on such investments, many of them choose hedging as one of the methods.