DEFINITION of 'De-hedge'

De-hedge refers to the process of closing out positions that were originally put in place to act as a hedge in a portfolio. De-hedging involves going back into the marketplace and closing out hedged positions, which were previously taken to limit an investor's risk of price fluctuations in relation to the underlying asset.

BREAKING DOWN 'De-hedge'

De-hedging is done when holders of an underlying asset have a bullish outlook on their investment. Therefore, investors would prefer to remove their hedged positions to gain exposure to the expected upward price fluctuations of their investment.

For example, a hedged investor in gold who feels the price of his asset is about to go up would buy back any gold futures contracts he had sold in the futures market. By doing this, the investor will have positioned himself to reap the rewards of an increase in the price of gold if his bullish prediction on gold is correct.

Hedging

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

There is a risk-reward tradeoff inherent in hedging: While it reduces potential risk, it also chips away at potential gains.

Derivatives are securities that move in terms of one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a rather crude hedge.

Why Investors Hedge and De-Hedge

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

The goal of hedging is not to make money but to protect from losses. The cost of the hedge—whether it is the cost of an option or lost profits from being on the wrong side of a futures contract—cannot be avoided. This is the price you pay to avoid uncertainty.

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