Hedging is a process investors use to protect themselves against adverse events in the future. In general, hedging is a strategy used to protect your investment in the stock market and increase profits. For hedging, a person or an entity needs another entity to enter into the strategy; these other parties are called counterparties. There are several ways to hedge an investment, but they all consist of agreements between you and the third party.
Difference between insurance and hedging
Insurance is a promise of compensation for specific potential future losses in exchange for a periodic payment. Insurance is designed to protect the financial well-being of an individual, company or other entity in the event of an unexpected loss.
Hedging is a bit like insurance. The share buyer takes out the assurance that he has a put option. It means that he cannot lose more than 20%. The speculator hopes to benefit from the fact that the chance of price falls is very small.
Hedging can be implemented in a variety of ways, including stocks, exchange-traded funds and insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and forward contracts.
Hedging and insurance are strategies for risk reduction. When you buy an insurance policy, you pay a premium to avoid risk without limiting your potential rewards. Hedging, on the other hand, is a financial strategy where potential financial gain is given up to avoid financial risk.
Suppose you are a farmer and you have a crop of corn that will be ready for harvest in two months. A buyer offers to pay you $5 per bushel when your harvest is done. If you accept the offer, you fix the price and are guaranteed to earn a minimum of $5 per bushel, regardless of what the market price is when your crop is ready. In this case, you are hedged against a future price drop below $5. However, your hedge also limits your earnings to $5, even if the price of corn sells for more than this amount when your crop is ready.
Now suppose that instead of offering you $5 a bushel of corn today, a buyer offers you a contract that gives you the right, but not the obligation, to sell your corn for $5 a bushel when it is ready for the harvest. The buyer will charge you $200 for this right. In this case, you are insured against a future price drop below $5 per bushel. However, if the market price for corn exceeds $5 when your crop is ready for harvest, you can sell it for the higher price; this way you insured against downside risk without limiting your potential profit.
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