What is a Hedging Transaction
A hedging transaction is a position that a market participant takes in order to limit risks related to another position or transaction that the market participant is involved in. The hedging transaction usually involves derivatives, such as options or futures contracts, but it can be done with inversely correlated assets as well. Hedging transactions are generally used to limit the losses that a position faces if the initial investing thesis is incorrect, but they can also be used to lock in a specific amount of profit. Hedging transaction are a common tool for businesses as well as portfolio managers looking to lower their overall portfolio risk.
BREAKING DOWN Hedging Transaction
Hedging transactions can be related to an investment or they can be related to regular business transactions, but the hedge itself is usually market based. An investment-based hedging transaction can use derivatives, such as puts or forward contracts, to cover assets that the investor is holding in hopes of appreciation. In this case, the hedging transaction sets a floor to the potential loss on the holdings. There is, of course, a cost to undertaking hedging positions, but these costs are often much lower than the potential losses facing these investors if their trade goes awry.
Hedging Meets Diversification
Investors can also use the purchase of inversely correlated assets to act as a hedge against overall portfolio risks presented from one asset or the other. For example, investors look for stocks that have a low correlation with the S&P 500 to get some level of protection from dips in value of the widely held stocks that make up the index. These types of hedging transactions are often referred to as diversification as they do not offer the direct protection that derivatives do.
Hedging Transactions in Global Business
Hedging transactions are critical for the global economy. For example, if domestic company A is selling goods to foreign company B, the first transaction is the sale. Let's say the sale is going to be settled in the currency of company B. If company A is worried about currency fluctuations affecting the value of the contract when the money actually comes in and is converted to company A's domestic currency, they can enter a hedging transaction through the foreign exchange market, taking up offsetting positions that minimize the currency risk.
It is worth noting that hedging transactions do not necessarily cover the total value of the sale or asset position. While a perfect hedge is possible, they are almost never employed. On the risk and reward tradeoff, eliminating all the risk takes away a lot of the reward. In hedging transactions, investors are trying to limit the downside risk, not eliminate it.