In finance Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some. There are many specific financial vehicles to accomplish this, including insurance policies In insurance, the insurance policy is a contract between the insurer and the insured, known as the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for payment, known as the premium, the insurer pays for damages to the insured which are caused by covered perils under the policy language. Insurance, forward contracts A forward contract or simply a forward is a non-standardized agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the, swaps In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the, options In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option, many types of over-the-counter Over-the-counter or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges and derivative A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties products, and perhaps most popularly, futures contracts In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They. Public futures markets A futures exchange or derivatives exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future were established in the 1800s to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They for hedging the values of energy In physics, energy is a quantity that is often understood as the ability to perform work. This quantity can be assigned to any particle, object, or system of objects as a consequence of its physical state, precious metals A precious metal is a rare, naturally occurring metallic chemical element of high economic value, which is not radioactive . Chemically, the precious metals are less reactive than most elements, have high lustre, are softer or more ductile, and have higher melting points than other metals. Historically, precious metals were important as currency,, foreign currency In economics, the term currency can refer either to a particular currency, for example the British Pound, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by, and interest rate An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to fluctuations.

Contents

Examples

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 Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity 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 a lot 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 Wheat is a grass, originally from the Fertile Crescent region of the Near East, but now cultivated worldwide. In 2007 world production of wheat was 607 million tons, making it the third most-produced cereal after maize (784 million tons) and rice (651 million tons). Globally, wheat is the leading source of vegetable protein in human food, having a at that time - the contract is an agreement to deliver a certain number of bushels of wheat on a certain date in the future for a certain fixed price to a specified place. 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.

Hedging a stock price

A stock trader A stock trader or a stock investor is an individual or firm who buys and sells stocks or bonds in the financial markets believes that the stock The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets A widget is a placeholder name for an object or, more specifically, a mechanical or other manufactured device. It is an abstract unit of production. The Oxford English Dictionary defines it as "An indefinite name for a gadget or mechanical contrivance, esp. a small manufactured item" and dates this use back to 1931; but the term appears. He wants to buy Company A shares to profit In neoclassical economics, economic profit, or profit, is the difference between a firm's total revenue and its opportunity costs. In classical economics profit is the return to the employer of capital stock in any productive pursuit involving labor. These two definitions are actually the same. In both instances economic profit is the return to an 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 In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money or the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some by short selling In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as an equal value (number of shares × price) of the shares of Company A's direct competitor Competition is a contest between individuals, groups, nations, animals, etc. for territory, a niche, or a location of resources. It arises whenever two or more parties strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For example, animals compete over water, Company B.

The first day the trader's portfolio Holding a portfolio is a part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to is:

(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 The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples) 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, goes up by 10%, while Company B goes up by just 5%:

(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):

Value of short position (Company B):

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1000 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.

Hedging fuel consumption

Main article: Fuel hedging Fuel Hedging is a contractual tool used by some airlines to stabilize jet fuel costs. A fuel hedge contract commits an airline to paying a pre-determined price for future jet fuel purchases. Airlines enter into such contracts as a bet that future jet fuel prices will be higher than current prices or to reduce the turbulence of confronting future

Airlines An airline provides air transport services for passengers or freight, generally with a recognized operating certificate or license. Airlines lease or own their aircraft with which to supply these services and may form partnerships or alliances with other airlines for mutual benefit use futures contracts In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They and derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties to hedge their exposure to the price of jet fuel Jet fuel is a type of aviation fuel designed for use in aircraft powered by gas-turbine engines. It is clear to straw-colored in appearance. The most commonly used fuels for commercial aviation are Jet A and Jet A-1 which are produced to a standardised international specification. The only other jet fuel commonly used in civilian turbine-engine. 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 Petroleum or crude oil is a naturally occurring, flammable liquid consisting of a complex mixture of hydrocarbons of various molecular weights, and other organic compounds, that are found in geologic formations beneath the earth's surface futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines Southwest Airlines Co. is an American low-cost airline. Southwest is the largest airline in the world by number of passengers carried per year (as of 2009). Southwest maintains the third-largest passenger fleet of aircraft among all of the world's commercial airlines. As of May 3, 2009, Southwest operates approximately 3,510 flights daily was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the US rose dramatically after the 2003 Iraq war Invasion – Post-invasion – Battles and operations – Bombings and terrorist attacks and Hurricane Katrina Hurricane Katrina of the 2005 Atlantic hurricane season was the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall. At least 1,836 people lost their lives in the actual hurricane and in the subsequent floods, making.

Types of hedging

The stock example above is a "classic" sort of hedge, known in the industry as a "pairs trade The pairs trade or pair trading, also known as market neutral, was developed in the late 1980s by quantitative analysts and pioneered by Gerald Bamberger while at Morgan Stanley. With the help of others at Morgan Stanley at the time, including Nunzio Tartaglia, Bamberger found that certain securities, often competitors in the same sector, were" 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.

Examples Of Hedging Strategies

various examples of hedging includes: 1)Forward exchange contract for currencies 2)currency future contracts 3)Money Market Operations for currencies 4)Forward Exchange Contract for interest(FRA) 5)Money Market Operations for interest 6)future contracts for interest

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

Financial Derivatives such as call and put options

Natural hedges

Many hedges do not involve exotic financial instruments or derivatives such as the married put A married put is formed when an investor buys shares of a stock and at the same time, a put option contract. See SEC definition of a married put in Section II of the following: . 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 In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured or policyholder is the person or to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.

Categories of hedgeable risk

For the following categories of the risk, for exporters The term "export" is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer". In International Trade, &, that the value of their accounting currency In economics, the term currency can refer to a particular currency, for example Pound Sterling, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by means of will fall against the value of the importers The term "import" is derived from the conceptual meaning as to bring in the goods and services into the port of a country. The buyer of such goods and services is referred to an "importer" who is based in the country of import whereas the overseas based seller is referred to as an "exporter". Thus an import is any, also known as volatility risk Volatility risk in financial markets is the likelihood of fluctuations in the exchange rate of currencies. Therefore, it is a probability measure of the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency. The volatility of the exchange rate is measured as standard deviation over a dataset of exchange rate.

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

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, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, factoring, or discounted bill.

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, as well as 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 economic activity to take place 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.

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.

There are many ways to hedge, and one is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE futures.

Another method to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone is 2, then for a 10000 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures (the Index that Vodafone trades in).

Futures hedging

If you primarily trade in futures, you hedge your 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.

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. For instance, consider a deal between an electricity producer and an electricity retailer who both 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.

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