A:

Hedging involves the concurrent use of more than one bet in opposite directions to limit the risk of serious investment loss. Arbitrage is the practice of trading a price difference between more than one market for the same good in an attempt to profit from the imbalance. These two concepts play important roles in finance, economics and investments.

Each transaction involves two competing types of trades: betting short versus betting long (hedging) and buying versus selling (arbitrage). Both are used by traders who operate in volatile, dynamic market environments. Other than these two similarities, however, they are very different techniques that are used for very different purposes.

Arbitrage

Arbitrage involves both purchase and sale within a very short period of time. If a good is being sold for $100 in one market and $108 in another market, a savvy trader could purchase the $100 item and then sell it in the other market for $108. The trader enjoys a risk-free return of 8% ($8 / $100), minus any transaction or transportation expenses.

With the proliferation of high-speed computing technology and constant price information, arbitrage is much more difficult in financial markets than it used to be. Still, arbitrage opportunities can be found in the forex market, in bonds, in futures markets and sometimes in equities.

Hedging

Hedging is not the pursuit of risk-free trades; instead, it is an attempt to reduce known risks while trading. Options contracts, forward contracts, swaps and derivatives are all used by traders to purchase opposite positions in the market. By betting against both upward and downward movement, the hedger can ensure a certain amount of reduced gain or loss on a trade.

Hedging can take place almost anywhere, but it has become a particularly important aspect of financial markets, business management and gambling. Much like any other risk/reward trade, hedging results in lower returns for the party involved, but it can offer significant protection against downside risk.

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