Hedging Risk Definition

Hedging is a strategy for reducing exposure to investment risk. An investor can hedge the risk of one investment by taking an offsetting position in another investment. The values of the offsetting investments should be inversely correlated.

Hedge Your Bet

When an investor buys a stock, he will profit if that stock goes up in value. However, the investor doesn’t know if the stock’s value will go up or go down. If the stock’s value goes down, he could incur a loss.
In order to protect against potential losses, the investor may want to hedge the risk. He could do this by investing in a financial instrument that will profit if the stock he owns, or a related security, decreases in value. Once the investment is hedged, the investor’s exposure to the risk of incurring a loss is reduced.
Hedging is similar to insurance. A homeowner might purchase fire insurance to hedge against the risk of losing his home in a fire.

Hedging Investments

Investors can use various techniques and financial instruments to hedge investments, including options contracts, futures contracts, short selling, investing in currencies, investing in commodities, and investing in other assets or derivatives.
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See Also:
Currency Exchange Rates
Currency Swap
Transaction Exposure
Exchange Traded Funds
Translation Exposure
Covariance
Hedge Funds
Put Option
ROCE (Return on Capital Employed)