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Hedging

Definition

To hedge, in the financial sense, is to reduce one's risk or exposure to a market. In equity markets, this means a reduction in systematic risk (also known as beta risk). In fixed income markets, one might hedge by reducing the duration of the portfolio. A commodity company might hedge its exposure to the spot commodity market by hedging its exposure to the market as well. This is accomplished with futures and forward contracts. Finally, a hedge may be implemented through the use of options i.e. buying puts, selling calls, or combining them both to form a collar on the position.

Using the term Hedging :

The worried portfolio manager decided to hedge his mutual fund by buying put options on the S&P 500 index. These options give him the right (but not obligation) to protect his portfolio if the market drops below the strike price.

Pay Special Attention To :

Hedging often helps, but it is important to note that it can also hurt. In the example above, the manager basically bought insurance and there was a fixed cost for this (the premium he paid for the options). In other instances, such as futures and forwards, the position may go against the manager (the price goes in a direction not anticipated) which will turn the hedge into a cost rather than a benefit. Ensure you understand the implications of your hedging instrument before attempting to hedge your portfolio. Always remember that the only long-term perfect hedge is to sell your position completely.

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Related terms

Hedge Fund , Trading , Duration , Beta , Leverage

'Hedging' appears in the definitions of these other terms:

Gold Swap Trading Yield Beta