The term “hedging” was originally used to describe the act of planting a hedge to protection or conceal property. In financial markets, hedging is the business of protecting wealth. Hedging is primarily a conservative investment strategy aimed at balancing possible stock market losses. Protection was originally the primary function of the now critically viewed hedge funds.
Hedging provides a trusted opporunity for the diversification of investment portfolios. The less closely related your individual investments are, the lower the risk of a major loss. A portfolio made up of Swiss stocks, commodity forwards and real estate investments will, as a whole, be less vulnerable to risk than any one investment option.
Hedging may also describe any attempt to insure against possible price fluctuations. In this process, the transaction to be hedged is accompanied by a second, additional transaction which (ideally) neutralizes the risk. In this way, hedging strategies are often used to compensate for fluctuations in interest, price or exchange rates. This is usually accomplished through time-specific agreements like forwards and futures.
Forward currency exchange contracts are a good example of hedging against possible exchange rate fluctuations. For example, an exporter which locks a future sale into the going currency exchange rate is protected from possible changes to rates. When the sale is made, they receive the agreed-on payment and are not affected by possible currency rate drops. However, they also do not benefit from possible favorable rate changes, and in that case do not profit from the currency exchange. This kind of hedging can be accomplished through currency futures trading or, on the stock market, by using futures to hedge securities purchases.
When trading on the stock market, the same principle can also be accomplished using forward contracts. This hedging strategy contractually obligates two entities to comply with a forward agreement. For example, a forward contract could be based on a specific commodity the price of which remains the same over a fixed period. The buyer profits if the price goes of the commodity goes up, because they can buy the commodities at the price defined in the forward contract is lower than the market rate. If the price of the commodity goes down, the seller profits because the price the buyer agreed to pay in the forward contract is higher than the market price.