Dynamic hedging is a type of financial management strategy that focuses on adjusting the hedge on an asset as the price of the underlying asset shifts. In some cases, the hedging activity will be triggered by changes in characteristics other than that price. This approach is different from any type of static approach to the hedge, since there is always the opportunity for making some adjustment when and as key factors related to the investment also change.
With dynamic hedging, the general idea is to adjust the hedge to compensate for any shifts in the pricing and other key factors associated with the underlying asset that supports the security. This is because changes in the status of the underlying asset will translate into changes in the value of the security itself. In order to protect the investment in the security, the ability to also shift the commitment to the fund or security will allow the investor to either take advantage of positive changes and maximize the return, or reduce the risk created by some sort of negative change.
Both linear and non-linear investments may be involved with the operation of the hedge fund. This means that underlying assets may include various types of futures as well as a wide range of securities that generate returns based on either a fixed or a variable rate of interest. Often, a hedge fund will include a combination of short and long options, such as using a non-linear position on a foreign option to balance out a linear position involving a spot trade on a domestic security. In addition, those assets may be domestic or international in origin. Given that those returns can fluctuate, using a dynamic hedging approach makes it easier to respond to the shifts in pricing for the underlying asset and be able to maintain a decent level of return overall.
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It is important to note that while a dynamic hedging approach can help to compensate for certain types of changes involving the underlying asset, this strategy does not completely eliminate the risk that investors assume in order to invest in a hedge fund. For this reason, investors need to understand how the particular hedge fund is managed, the range of assets that are held by the fund, and the past history of those assets. Doing so will go a long way toward making the right choice in terms of buying into the fund, and also make it easier to determine when and how dynamic hedging may be appropriate.