Last edited 26 Apr 2019

Financial hedging

Contents

[edit] Introduction

In common parlance, ‘hedging one's bets’ usually involves putting something in place to protect the individual from a possible loss or negative future event. It is taking a parallel action to offset something that might happen which is thought might result in a loss or unfortunate state of affairs. Buying home insurance is a hedge against burglary, fire and other calamities.

[edit] Financial hedging

Similarly, in the finance sector, a hedge is a risk management strategy used to protect against a possible financial loss. It is a counterbalancing tool that protects individuals or companies from a loss that may be incurred in some parallel financial investment. It is important to remember that hedging does not usually make investors money, but protects them from financial loss.

A hedge may comprise one or many different types of financial investments such as stocks, insurance, forward contracts, exchange-traded funds and options. In creating this hedge, an individual or company may take an opposing position in one investment or market to balance a risk that may be incurred in a contrary investment or market. The risk, should it occur, will usually be to do with adverse price movements

[edit] Long and short hedges.

Long and short hedges are both classed as ‘futures’ and can be favourable as they iron-out price volatility in a market.

A long hedge contract allows a company (Company A) to buy - say copper - at a specific price at a set date in the future. If the price of copper rises before the contract expires, company A has saved money by paying a lower price (otherwise it would have bought copper at a higher price); however, if the price of copper falls, company A loses out as it must still pay the higher price agreed to in the contract. In that case, the hedge has been costly and it would have been better not to have hedged at all.

A short hedge protects against the price of an asset falling at some point in the future. For example, an aluminium producer (company B) might enter into a contract (short hedge) to lock into a preferred sale price allowing it to sell aluminium at a specified future price. Should the price of aluminium fall below that price during the contract period, company B can sell at the (higher) price it agreed to in the contract and will have reduced its losses and earned a profit.

[edit] Reasons to hedge

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