Hedging

A hedge works by offsetting risk. If the main position loses value, the hedge gains value, or at least limits the loss.

Businesses hedge to make their costs and revenues more predictable. An airline might buy fuel futures to lock in the price of jet fuel for the coming year. If fuel prices rise, the airline pays more for fuel but gains on the futures, so its overall cost stays roughly the same. An exporter expecting payment in a foreign currency might use a forward contract to fix the exchange rate in advance.

Investors also hedge. Someone holding shares worth 50,000 might buy put options that rise in value if the shares fall, limiting their potential loss.

For example, a European company due to receive 1 million US dollars in six months could agree a forward exchange rate of 1.10 dollars per euro today. Whatever happens to the exchange rate, it will receive about 909,000 euros.

Hedging has costs, such as option premiums or fees, and it usually limits potential gains as well as losses. If prices move favourably, the hedger gives up some of the benefit. The aim of hedging is not to make money but to reduce uncertainty.