Hedging

Definition

Hedging is a risk management strategy used to offset potential losses by taking an opposite position in a related asset. It aims to reduce the impact of price fluctuations and market volatility on investments.

5 Must Know Facts For Your Next Test

1. Hedging can involve derivatives like options, futures, and swaps.
2. The primary goal of hedging is to minimize risk rather than maximize profit.
3. Hedging can protect against various types of risk including interest rate risk, currency risk, and commodity price risk.
4. Companies often use hedging techniques to stabilize cash flows and earnings.
5. Effective hedging requires understanding of both the underlying asset and the instrument used for hedging.

Review Questions

• What is the main objective of hedging in financial management?
• Name at least two financial instruments commonly used in hedging strategies.
• How does hedging help companies manage cash flow volatility?

Related terms

Derivative: A financial security whose value is dependent upon or derived from an underlying asset or group of assets.

Futures Contract: An agreement to buy or sell an asset at a future date at an agreed-upon price.

Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specified price before a certain date.