Meaning and Definition of Hedge
A hedge is, generally, an investment position projected to make up for potential losses which might be incurred by a cohort investment. In theoretical terms, a hedge refers to an investment made to reduce the risk of unfavorable price movements in an asset. The strategy of hedge is used by the investors when they are not sure of future market conditions and prices.
For example, a business owner has a stock. He sells a futures contract stating that he will sell this stock at a particular price, thus avoiding market fluctuations. A perfect hedge, would, therefore, reduce the risk to nothing.
The process of Hedging
The techniques adopted for hedging usually involve using complicated financial instruments which are referred as derivatives which include ‘options’ and ‘futures’ as the most common ones. These instruments help in developing the trading strategies wherein a loss in one investment is compensated by a gain in a derivative. Well, since there are numerous different kinds of options and futures contracts, it is possible for an investor to hedge against almost anything, like a commodity price, a stock, currency, and interest rate. Adding more, investors can hedge even against weather.
The downside of Hedging
Besides the benefits, every hedging also has a cost. It is, therefore, essential for an investor, before opting to use hedging, to confirm whether the benefits received from that particular hedging validate the expense incurred on the same. It is noteworthy that the key objective of hedging does not lie in making money but in protection from losses. The cost of the hedge cannot be avoided, be it lost profits from being on the erroneous side of a futures contract or the cost of an option. This is the price which has to be paid to avoid uncertainty.
A hedging portfolio is, however, not a perfect science and things might sometimes go wrong. Although there are risk managers who always aim at a perfect hedge but it is, however, somewhat difficult to be achieved in practice. But, you, as an investor, can work on hedging in a better way to protect yourselves through a better basic knowledge of hedging.