What does Hedge mean

By | 24/09/2016

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.

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