Hedging is basically done to reduce the risk of your current investment positions.

Lets say you

are long on a stock (ABC), now if shares of ABC drop significantly you may lose your profit or
increase your losses.

To counter that, you may buy a put option contract on ABC which allows you to sell your shares
at a specified price before the contract expires. Now, if ABC drops below the contract price, you
can execute your put option (contract) and sell your shares (to the option's writer) at a price
higher than the market. Thus, you have the ability to lock in a guaranteed price for your asset no
matter what the market price is.

Hedging Through Stock Options

 If an investor buys a stock at $52 expecting it to rise to $60, he can limit his
risk by buying a put option at a strike price of $50. A put option seller pays a
small fee (assume $1 for this illustration) for the right to sell the stock to another
investor if the stock drops to $50 or lower. The investor's effective cost is then
$53. The put seller's cost is $49. If the stock reaches $60, the investor makes $7
(also called points). The investor has hedged his risk at $50 for the price of 1
point. If the stock drops to $45, the put buyer has only lost 3 (52 +1 -50) points.
Thus the anticipated risk to reward ratio is 7 to 3, or 233 percent.

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of wheat and other crops
fluctuate constantly as supply and demand for them vary, with occasional large moves in either
direction. Based on current prices and forecast levels at harvest time, the farmer might decide
that planting wheat is a good idea one season, but the forecast prices are only that: forecasts.
Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual
price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of
unexpected money, but if the actual price drops by harvest time, he could be ruined.

If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting
time, he effectively locks in the price of wheat at that time: the contract is an agreement to
deliver a certain number of bushels of wheat to a specified place on a certain date in the future
for a certain fixed price. He has hedged his exposure to wheat prices; he no longer cares whether
the current price rises or falls, because he is guaranteed a price by the contract. He no longer
needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the
chance at making extra money from a high wheat price at harvest times.

[edit] Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month, due to
the company's new and efficient method of producing widgets. He wants to buy Company A
shares to profit from their expected price increase. But Company A is part of the highly volatile
widget industry. If the trader simply bought the shares based on his belief that the Company A
shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the
industry risk by short selling an equal value (number of shares × price) of the shares of Company
A's direct competitor, Company B.

The first day the trader's portfolio is:

 Long 1,000 shares of Company A at $1 each

 Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares.)

If the trader was able to short sell an asset whose price had a mathematically defined relation
with Company A's stock price (for example a call option on Company A shares), the trade might
be essentially riskless. But in this case, the risk is lessened but not removed.

On the second day, a favorable news story about the widgets industry is published and the value
of all widgets stock goes up. Company A, however, because it is a stronger company, increases
by 10%, while Company B increases by just 5%:

 Long 1,000 shares of Company A at $1.10 each: $100 gain

 Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the Company A
position. But on the third day, an unfavorable news story is published about the health effects of
widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the
course of a few hours. Nevertheless, since Company A is the better company, it suffers less than
Company B:

Value of long position (Company A):

 Day 1: $1,000
 Day 2: $1,100
 Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):

 Day 1: −$1,000
 Day 2: −$1,050
 Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has
used in short selling Company B's shares to buy Company A's shares as well). But the hedge –
the short sale of Company B – gives a profit of $475, for a net profit of $25 during a dramatic
market collapse.

[edit] Hedging fuel consumption

Main article: Fuel hedging

Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel.
They know that they must purchase jet fuel for as long as they want to stay in business, and fuel
prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel
requirements (and engaging in similar but more complex derivatives transactions), Southwest
Airlines was able to save a large amount of money when buying fuel as compared to rival
airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane
Katrina.

[edit] Types of hedging

The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due
to the trading on a pair of related securities. As investors became more sophisticated, along with
the mathematical tools used to calculate values (known as models), the types of hedges have
increased greatly.

[edit] Hedging strategies

Examples of hedging include:

 Forward exchange contract for currencies

 Currency future contracts
 Money Market Operations for currencies
 Forward Exchange Contract for interest (FRA)
 Money Market Operations for interest
 Future contracts for interest

This is a list of hedging strategies, grouped by category.

[edit] Financial derivatives such as call and put options

 Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of
simulating being long a stock or commodity position.
 Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash
flow by dynamically re-hedging to maintain a market neutral position. This is also a type of
market neutral strategy.

[edit] Natural hedges

Many hedges do not involve exotic financial instruments or derivatives such as the married put.
A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e.
revenues and expenses.

For example, an exporter to the United States faces a risk of changes in the value of the U.S.
dollar and chooses to open a production facility in that market to match its expected sales
revenue to its cost structure. Another example is a company that opens a subsidiary in another
country and borrows in the local currency to finance its operations, even though the local interest
rate may be more expensive than in its home country: by matching the debt payments to
expected revenues in the local currency, the parent company has reduced its foreign currency
exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces
costs in a different currency; it would be applying a natural hedge if it agreed to, for example,
pay bonuses to employees in U.S. dollars.

One of the oldest means of hedging against risk is the purchase of insurance to protect against
financial loss due to accidental property damage or loss, personal injury, or loss of life.

[edit] Categories of hedgeable risk

For the following categories of risk, for exporters, that the value of their accounting currency
will fall against the value of the importers, also known as volatility risk.

 Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or
a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using
fixed-income instruments or interest rate swaps.
 Equity: the risk (or sometimes reward), for those whose assets are equity holdings, that the
value of the equity falls.
 Securities lending: hedged portfolio stock secured loan financing is a form of individual portfolio
risk reduction that typically results in a limited recourse loan.

Futures contracts and forward contracts are means of hedging against the risk of adverse market
movements. These originally developed out of commodity markets in the 19th century, but over
the last fifty years a large global market developed in products to hedge financial market risk.

[edit] Hedging credit risk

Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the
natural business of banks, but an unwanted risk for commercial traders, an early market
developed between banks and traders that involved selling obligations at a discounted rate. (See
forfeiting, bill of lading, factoring, or discounted bill.)

[edit] Hedging currency risk

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial
investors to parse out the risks they encounter when investing abroad and by non-financial actors
in the global economy for whom multi-currency activities are a necessary evil rather than a
desired state of exposure.

The financial investor may be a hedge fund that decides to invest in a company in, for example,
Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can
separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the
Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is
effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk
to someone else who wants to take up a position in the currency. The hedge fund has to pay this
other investor to take on the currency exposure, similar to insuring against other types of events.

As with other types of financial products, hedging may allow for economic activity that would
otherwise not have been possible (as a loan, for example, may allow an individual to purchase a
home that would be "too expensive" if the individual had to pay cash). The increased investment
is assumed in this way to raise economic efficiency.

[edit] Hedging equity and equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your
stock picking against systematic market risk, you short futures when you buy equity, or long
futures when you short stock.

One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount
in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone
and shorting 10,000 worth of FTSE futures.

Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an
index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an
investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the
index in which Vodafone trades).

[edit] Futures hedging

Investors who primarily trade in futures may hedge their futures against synthetic futures. A
synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic
futures means long call and short put at the same expiry price. So if you are long futures in your
trade you can hedge by shorting synthetics, and vice versa.

[edit] Contract for difference

A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and
purchaser to fix the price of a volatile commodity. Consider a deal between an electricity
producer and an electricity retailer, both of whom trade through an electricity market pool. If the
producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period,
and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20
(the "difference" between the strike price and the pool price) to the retailer. Conversely, the
retailer pays the difference to the producer if the pool price is lower than the agreed upon
contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive
$50 per MWh. However, the party who pays the difference is "out of the money" because
without the hedge they would have received the benefit of the pool price.