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strategy used to offset investment risk. A perfect hedge is one eliminating the possibility of future gain or loss.
A stockholder worried about declining stock prices, for instance, can hedge his or her holdings by buying a put option on the stock or selling a call option . Someone owning 100 shares of XYZ stock, selling at $70 per share, can hedge his position by buying a put option giving him the right to sell 100 shares at $70 at any time over the next few months. This investor must pay a certain amount of money, called a premium , for these rights. If XYZ stock falls during that time, the investor can exercise his option-that is, sell the stock at $70-thereby preserving the $70 value of the XYZ holdings. The same XYZ stockholder can also hedge his position by selling a call option. In such a transaction, he sells the right to buy XYZ stock at $70 per share for the next few months. In return, he receives a premium. If XYZ stock falls in price, that premium income will offset to some extent the drop in value of the stock.
selling short is another widely used hedging technique.
Investors often try to hedge against inflation by purchasing assets that will rise in value faster than inflation, such as gold, real estate, or other tangible assets.
Large commercial firms that want to be assured of the price they will receive or pay for a commodity will hedge their position by buying and selling simultaneously in the futures market . For example, Hershey's, the chocolate company, will hedge its supplies of cocoa in the futures market to limit the risk of a rise in cocoa prices.Managers of large pools of money such as pension and mutual funds frequently hedge their exposure to currency or interest rate risk by buying or selling futures or options contracts. For example, a global mutual fund manager with a large position in Japanese stocks who thinks the Japanese yen is about to fall in value against the U.S. dollar may buy futures or options on the Japanese yen to offset the projected loss on the currency.
financial technique to offset the risk of loss from price fluctuations in the market. Hedgers employ a variety of techniques, including futures contracts, options on futures, and interest rate swaps. An investor wanting protection against a fall in price can sell forward contracts ( a long hedge ); in the futures market, to protect against a rise in price, the investor buys forward contracts (a short hedge ); For example, a borrower in the money market can use interest rate futures as protection against increases in short-term rates with a short or sell hedge, by selling an interest rate contract for future delivery. If rates happen to rise between the contract sale date and the delivery date, the value of the futures contract will drop and the hedger can make a gain by buying back, at a lower price, the contract sold earlier.
Other forms of hedging involve purchase of interest rate and currency options, interest-only (io) securities and principal-only (PO) strip and residual tranches of a Collateralized Mortgage Obligation .
See also short sale , cross-hedge , covered interest arbitrage , arbitrage , derivative mortgage-backed securities , tranchenaked position
perfect hedge
special arbitrage account
stock index future
arbitrage
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