Hedging

Hedging

Explanation: Hedging is a risk management strategy used to offset potential losses in an investment by taking an opposite position in a related asset. It involves using financial instruments such as derivatives (options, futures, swaps) to protect against adverse price movements. Hedging reduces risk but also limits potential gains.

Example: An airline company hedges against rising fuel prices by purchasing oil futures contracts. If fuel prices increase, the gains from the futures contracts offset the higher fuel costs, stabilizing the company’s expenses.

Reference Link: For more information on hedging, visit Investopedia’s Hedging.

FAQs:

1. What is the purpose of hedging?
   • The purpose is to reduce risk and protect against adverse price movements in an investment.
2. What are common hedging instruments?
   • Common instruments include options, futures, forwards, and swaps.
3. Can hedging eliminate all risk?
   • No, hedging reduces risk but cannot eliminate it entirely. It also limits potential gains.
4. Who uses hedging strategies?
   • Hedging is used by investors, companies, and financial institutions to manage risk.
5. What is the cost of hedging?
   • The cost includes the premiums paid for derivatives and the potential opportunity cost of limiting gains.