By Reya Kak (Aravali International School)
Hedging in layman language is used to minimize the risk that any individual thinks he will have to face in the future. Hedging is done when the individual buys a commodity at a current price and side by side short sells it in the futures market. For e.g. if I buy 30 kg gold and it was predicted that the prices of gold may decrease, then I would short sell the same quantity to get back to a no profit no loss situation.
There are two types of hedging, one is a short hedge and the other is a long hedge. A short hedge is generally done to minimize the downside risk whereas a long hedge is done to prevent the loss in a short position due to an increase in the price. E.g. of short hedge: supposing I own an asset of 20 million and it is expected that the price of that asset will go down to 15 million then straight out 5million will be the loss. To prevent that loss, I will use a short hedge. Although hedging is done to minimize the risk, the chances of earning profit and losses are both possible. A position of profit may occur when the gap between the buying of the commodity and the short-selling of that commodity decreases, i.e., the spread between them decreases. For e.g. gold is bought for 50,000 and is sold for 55,000, then the spread between them is 5,000. However, if the spread between theM decreases to 4,000, then the price at which that commodity is bought will increase to 50,500 and the price at which it is sold will decrease to 54,500. The profit gained by that commodity is now 1,000. A position of loss may occur when the gap between the buying of the commodity and the short-selling of that commodity increases i.e., the spread between them increases. for e.g. gold is bought for 50,000 and is sold for 55,000, then the spread between them is 5,000. However, if the spread between them increases to 4,000, then the price at which that commodity is bought will decrease to 54500 and the price at which it is sold will increase to 55,000. The loss incurred by that commodity is now 1,000.
The intensive fees or the brokerage given to the managers are followed according to their performances. The fee structure is carried out on 220 or 2plus 20% structure which means that they charge 2% as the payment amongst the assets which they have managed plus an additional 20% of the profits specified up to a benchmark. Here the hurdle rates, as well as the high-water mark, are facilitated. The hurdle rates mean that there are certain hurdles or benchmark that has to be accomplished before providing the incentives. The High-water mark means that there would be a benchmark set after establishing the hurdle rates, and if the mark is less than the hurdle rate then the payments are not to be done. For e.g. the watermark is set to be 3% for the first incentive, for the second incentive it increased to 3% and for the third to fell down to 3%, then the incentive for the third round is not necessarily payable.