Hedging

1. Definition

Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. * Think of it as "Investment Insurance." The primary goal is not to maximize profit, but to minimize potential loss.

2. Mechanism

"If I lose money on Asset A, I make money on Asset B." * Concept: Combining a Long position in the underlying asset with a Short position in a derivative (or vice versa).

Example: The Airline Industry

• Risk: An airline company is worried that jet fuel prices will skyrocket, increasing their operating costs.
• Hedge: The airline buys Crude Oil Futures (Long Futures).
• Result: If oil prices rise, the extra cost of fuel is offset by the profits from the futures contract.

3. The Cost (No Free Lunch)

Hedging always comes with a trade-off. 1.  Direct Cost: Paying premiums for options. 2.  Opportunity Cost: It caps your potential upside. If the market moves in your favor, your hedge position will lose money, reducing your total profit.

4. Common Types

• Currency Hedging: Exporters sell currency futures to protect against exchange rate drops.
• Portfolio Hedging: Investors buy Put options (Protective Put) to insure their stock portfolio against a market crash.

5. Summary

Hedging is about reducing volatility. While it reduces potential gains, it prevents catastrophic losses, ensuring survival in unpredictable markets.