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Hedge

• Hedging is a strategy of reducing risk by offsetting investments with investments of opposite risk. Risks must be negatively correlated in order to hedge each other; for example, an investment with high inflation risk and low immediate returns with investments with low inflation risk and high immediate returns. Long hedges protect against a short-term position and short hedges protect against a long-term position.

• To reduce risk, (1) by taking a position in futures equal and opposite to an existing or anticipated cash position, or (2) by shorting a security similar to one in which a long position has been established. Pre-sale or pre-purchases of anticipated future sales and purchases to lock-in a current price and avoid price fluctuations.

• An investment made in order to reduce the risk of adverse price movements in a security. Normally, a hedge consists of a protecting position in a related security.

• A transaction that reduces the risk of an investment.

• Is the act of protecting a position. Hedges can be either Long or Short. Hedges are often done with derivative products. A Long Hedge refers to a position whereby a derivative contract is purchased to protect against a short actual position. A Short Hedge is a position whereby a derivative is sold to protect against a long actual position.

 
 Embedded terms in definition
 Cash
Contract
Derivative
Futures
Future
Hedging
Inflation risk
Inflation
Investments
Long hedge
Long position
Long
Negatively correlated
Order
Position
Risk
Sales
Security
Short hedge
Short
 
 Referenced Terms
 Alternative investments: Are usually investments other than mutual funds, certificates of deposit, or direct investments in equities and bonds. Some of these alternatives are: art, collectibles, commodities, commodity funds, commodity pools, derivatives, foreign exchange, Hedge funds, oil and gas, precious metals, and real estate ventures.

 Anticipatory hedging: Refers to the placement of a Hedge prior to placement of the actual position. Sometimes, this occurs when a firm knows that it will receive investment funds later that day or week and prefers to hedge numerous potential risks at the earlier date. Similarly, a commodity producer may prefer to hedge prior to the harvest of a crop, production of an energy product or processing a raw material into a deliverable lot.

 Basis risk: Is the risk in the basis time series. This can be influenced by many variables although the total impact is less than the exposure for a naked position. When a Hedge is placed, price risk is transformed into basis risk. Basis risk is substantially less than price or inventory risk in terms of dollars.The uncertainty about the basis at the time a Hedge may be lifted. Hedging substitutes basis risk for price risk.

 Basis risk: Is the risk in the basis time series. This can be influenced by many variables although the total impact is less than the exposure for a naked position. When a Hedge is placed, price risk is transformed into basis risk. Basis risk is substantially less than price or inventory risk in terms of dollars.The uncertainty about the basis at the time a Hedge may be lifted. Hedging substitutes basis risk for price risk.

 Convertible securities hedge funds: Generally look to purchase the bonds or preferred securities and sell common shares against these long positions. The intent is to Hedge interest or dividend paying securities with low or no dividend common shares. In the event of a default the bonds and other securities have priority to the common shares. Also, the bonds or preferred stocks usually generate positive cash flows whereas the short positions are generally not responsible for dividend payments. Therefore the fund should have a positive cash flow and protected by relative seniority position in corporate securities. These funds also use warrants and options as portfolio instruments.

 
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