Hedging Risk

Hedging is a tool used by individual investors and companies to manage risk. When a company has a transaction or investment position that exposes it to some type of risk, it can use a hedge to reduce or eliminate the risk. A hedge is an offsetting transaction, structured so that if the original transaction causes an adverse outcome, the hedge will create a positive outcome to at least partially cancel out the adverse outcome from the original transaction. Of course, the opposite is also true. If the original transaction causes a positive outcome, the hedge will create a negative outcome that will at least partially cancel out the positive outcome.

The purpose of a hedge is not to guarantee a positive outcome but to reduce or eliminate risk.

Derivatives are one of the primary means of hedging because they are financial instruments whose value is derived from some other asset.

Four types of derivatives are typically used to create hedges: forward contracts, futures contracts, swaps, and options