Hedging is a financial strategy used to reduce or eliminate risks associated with price fluctuations in financial assets. This is done by taking an opposing financial position in another asset that is closely linked to the original asset.
Types of Hedging:
1. Full Hedging: Involves completely reducing risk by taking an opposing financial position to the original asset.
2. Partial Hedging: Involves partially reducing risk by taking a partially opposing financial position to the original asset.
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Hedging Instruments:
1. Futures: Contracts that obligate the buyer to purchase a specific asset at a predetermined price on a future date.
2. Call and Put Options: Contracts that give the buyer the right to buy or sell a specific asset at a predetermined price on a future date.
3. Swaps: Contracts that allow the exchange of cash flows between two parties.
Benefits of Hedging:
1. Risk Reduction: Hedging can help reduce potential losses resulting from price fluctuations.
2. Increased Stability: Hedging can help increase the cash flow stability of companies.
3. Improved Risk Management: Hedging can help improve the financial risk management of companies.
Hedging Risks:
1. Hedging Costs: The cost of hedging can be high, especially if prices fluctuate significantly.
2. Opportunity Loss: Hedging may lead to missed opportunities for profit if prices move in the expected direction.
3. Credit Risk: There may be credit risks if the other party fails to meet its obligations under the hedging contract.