Definition
Hedging involves taking an offsetting position to protect against losses in an existing exposure. Perfect hedges eliminate all risk but also all upside. Most real-world hedges are imperfect due to basis risk. Common hedging instruments include futures, options, swaps, and forwards. The cost of hedging (premiums, opportunity cost) must be weighed against the risk reduction benefit.
lightbulb Example
An airline hedges 60% of its fuel needs with crude oil futures, locking in $80/barrel for next quarter. If oil rises to $95, the hedge saves $15/barrel on 60% of consumption. If oil drops to $70, the airline loses $10/barrel on hedged portion but benefits on the unhedged 40%.
verified_user Key Points
- Reduces exposure to adverse price movements
- Perfect hedge eliminates all risk and upside
- Basis risk prevents perfect hedging in most cases
- Cost of hedging vs cost of not hedging is the key trade-off