Definition of 'Hedge'
Hedge (noun) is an investment that guards against an asset’s adverse price movement, thereby reducing the investor’s risk. As a verb, one hedges against negative consequences in the market in the same way that one “hedges his or her bets,” and some observers draw the analogy of taking out an insurance policy.
TheStreet Explains ‘Hedge’
Hedges come in a few shapes and sizes, but all are engineered to minimize risk (even if, at the same time, they end up minimizing reward)—and hedges are employed by individual investors, portfolio managers, and even companies in order to create a relatively secure position for themselves. Let’s say that the managers at ACME Chair Corporation, makers of fine, Shaker-style rocking chairs, are worried about the volatility in the price of maple wood—if the price goes up unexpectedly and dramatically next year, ACME’s profit margin would suddenly become a lot smaller. In order to hedge against the volatility of maple wood prices, ACME may elect to purchase a futures contract in order to buy that wood at a specific price in six months. Even if the price goes up just a little at that time, ACME is still secure in purchasing it at the original, lower price. That would be considered a successful hedge and, if the price of maple wood shoots up a lot, then that would be considered a very successful hedge.
But, because we are talking about the risk-reward tradeoff, ACME may suffer just a little if the price of maple wood goes down before that pre-determined futures contract date—effectively paying more for its raw material than it would have if it had just waited and watched. But, because the futures contract enabled ACME to create a known variable—the future price of its raw material—it was nonetheless able to adequately budget for that price, whether it’s lower or higher than the actual market price at that time. Therein is a huge benefit for a company that already has a meager profit margin and needs to create as much certainty as possible in order to be profitable.
Companies—or even individual investors—can hedge through other means, as well, notably by diversifying their portfolios to spread out the risk, or more commonly, and through derivatives.
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