Definition of Hedging

Definition of Hedging – Setting up an investment positions which helps to protect against losses from a related investment.

For example, if you export goods to the US, an appreciation in the exchange rate can make your exports uncompetitive. Therefore, you can hedge against your position by buying Sterling futures. If sterling appreciates, your exports become uncompetitive, but you benefit from the rise in the value of Sterling.

When weighing up what to buy and where to invest some speculators may wish to hedge against risky investment.

A simple way to engage in hedging is to buy a safe asset for every risky asset. However, some people may want to hedge against a particular investment. This can be done by using derivatives.

Hedging with Put Options

An example is using a put option. This gives the owner the right, but not the obligation, to sell at a certain fixed price, before a certain date.

This means that if the share price falls more than the agreed price (striking price) then you can sell it.

Example, suppose you buy shares in ICI for 100p, hoping they will increase in value. To hedge, you could also take out a put option, which gives you the right to sell shares in ICI for 80p in the next 6 months. This means that if shares in ICI fall by 30%, the investor can sell at 80p.

The person who sells the put option hopes to make money from the fact that the hedger pays a premium. The speculator hopes that the share price in ICI will not fall below 80p.

However, if the share price does fall below 80p, it is obliged to buy all shares at this price. If the market price has collapsed to 20p they will make a big loss.

Hedging and Insurance

Hedging is a bit like insurance. The share buyer takes out the insurance of having a put option. It means he can’t lose more than 20%. The speculator hopes to make a profit from the fact the chance of share prices falling is very low.

Hedging can be implemented in a variety of ways including: stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

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