Best Ways to Understand Hedging

Many a times, a financial broker or an advisor may be liable to a customer for failing to recommend to the customer to hedge their portfolio. Liability in this context usually arises when a customer has a portfolio that is concentrated in few companies or few industries leave the customer open to devastating losses if those companies or sectors turn sour.

The Brokers have a duty to provide investment advice which is suitable for the client and is in the client’s best interests. This includes a client’s ultimate financial goals and their tolerance for risk. Hedging a portfolio helps in reducing risks. If a client is not provided advice about the use of hedging in their account, the broker may have some liability issues.

Liability for failure to hedge reflects a broker’s duty to make suitable recommendations which generally encompass the use of sound financial planning which includes diversification. In some cases, it would be unsuitable for a client to diversify a large holding into one or more securities; but, this does not discharge a broker’s duty to make suitable recommendations, which includes recommendation to hedge a portfolio.

If you think of hedging as a type of insurance, it is the best way to understand it. People insure themselves against a negative event when they decide to hedge. This does not prevent a negative event from happening. But if at all it happens and they are properly hedged, the impact of the event is surely reduced.

There is always some form of risk taking that is inherent to any investment, no risk–no reward. In most of the cases the portfolio managers should use hedging techniques in order to reduce their customer’s exposure to various risks. In order to avoid against any investment risk by strategically using instruments in the market to offset the risk of adverse price movements, these financial managers or advisors should recommend help to reduce risks. In other words, the investors hedge one investment by making another.

Technically, whenever an investment is to be hedged, two securities with negative correlations are made. Hedging does not address the risk-return tradeoff. A reduction in the risk will usually mean a reduction in the potential profits. Therefore, hedging, for most of the time, is a technique where the customers will hopefully still make money but reduce potential losses.

Losses suffered just because a broker has failed to recommend an appropriate hedging strategy, may be recovered by filing a claim.