It is nothing but making an investment to reduce the risk of undesirable price movements in an asset. In general, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
A best example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.
Investors use this strategy when they are uncertain of what the market will do. A perfect hedge reduces your risk to zero (except for the cost of the hedge).
In finance, a hedge is a position established in one market in an attempt to counterbalance exposure to the price risk of an equal but opposite obligation or position in another market — generally, but not all the time, in the context of one's commercial activity. Hedging is a strategy designed to minimize exposure to such business risks as a sharp reduction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory.
A characteristic hedger might be a farmer with 2000 acres of unharvested wheat in the ground, who would rather tend his crop without the interruption of uncertain prices. He's a farmer, not an entrepreneur, yet his unharvested "inventory" may have lost 35% of its value ($285,000) in the three months he's been planning his planting. He might have decided he could live with a price of only eight or nine dollars a bushel, and to offset his planted position with an more or less equal but opposite position in the market for wheat on the Minneapolis Grain Exchange by selling ten wheat futures contracts for December delivery. This farmer is in this manner a hedger indifferent to the movements of the market as a whole, and has reduced his price risk to the difference between the price he will receive from a local buyer at harvest time, and the price at which he will concurrently liquidate his obligation to the Exchange.
Holbrook Working, a pioneer in hedging theory, called this approach "speculation in the basis," where the basis is the distinction between today's market value of (in this example) wheat and today's value of the hedge. If that dissimilarity widens, he earns a little more at harvest time. If that difference narrows, he earns a little less. He has mitigated, but not eliminated, the risk of losing the value of his wheat as of the day he recognized his hedge.
Some type of risk taking is natural to any business activity. Several risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other kind of risk are not required, but cannot be avoided without hedging. Somebody who has a shop, for instance, expects to face expected risks such as the risk of competition, of poor or unpopular products, and so on.
The risk of the shopkeeper's inventory being destroyed by fire is redundant, nevertheless, and can be hedged via a fire insurance contract. Not all kinds of hedges are financial instruments: a producer that exports to another country, for case, may hedge its currency risk when selling by connecting its expenses to the desired currency. Banks and other financial institutions use make use of hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
A hedger (such as a manufacturing company) is thus notable from an arbitrageur or speculator (such as a bank or brokerage firm) in derivative purchase behavior.
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