What is hedging?
In finance and trading, hedging is a strategy to reduce the risk of being at the mercy of large in priceWhat are value stocks? A value company is a company that app... More.
To hedge against a loss from a priceWhat is price? The price is the measure of the value of good... More fluctuation, you usually open an offsetting in a related .
and use hedging when they are unsure of which way the marketWhat are value stocks? A value company is a company that app... More will move. Ideally, hedging will slash any risk to zero or near zero, and cost only the .
The hedge ratio compares either the value of a hedged position to the total size of the position or the value of a purchased futuresA future is a contract between two parties to purchase a c... More contract to the value of the commodity being hedged.
De-hedging basically involves closing out any hedged positions you hold by returning to the markets when your underlying asset looks bullish and removing the hedge so you can profit from its rising price.
Options & futures example
You sold a 3-month for wheat and are worried that the price will increase significantly. As a hedge, you could buy a on wheat that guarantees you an acceptable price in 3 months time.
Note that in this example, if the option would not be exerted, you would actually still need to buy the wheat in 3 months. This, in turn, is an example that hedging rarely is a “free lunch” and needs to be considered carefully.
Commodity hedge example
An airline wants to ensure it doesn’t lose moneyMoney is a generally accepted medium of exchange to buy and... More on the seats it has sold because of rising prices. The airline could buy oil options or futures as a hedge. Even if it does not use the oil directly themselves (because they do not own a refinery), a rising oil price would earn them money on these trades, while costing them money in their operative business.
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