The term hedging relates to a financial transaction designed to hedge against risks such as currency fluctuations or changes in commodity prices. The person or company intending to hedge a transaction (also called hedgers), implements such a transaction as a supplementary measure to the underlying transaction.
This usually takes place in the form of a forward contract. A perfect hedge eliminates all risk, but in practice this is almost impossible.
The hedging transaction is based on the intention to establish a currently perceived position as an acceptable price, such as the stock price of a security, the exchange rate of a currency or an interest rate of the future.
In essence, hedging transactions involve the purchase or sale of a financial asset that is correlated with the item you want to establish coverage on.
Hedging operations can in principle, be carried out both with exchange traded instruments such as futures and options (often known as portfolio insurance) as well as over the counter in so-called OTC markets using non-standard derivatives.
The success of the hedging transaction is based on a balancing effect of the volatility of the underlying transaction price by a counter-balancing involvement in the futures market. If price direction and extent of price changes in spot or futures market are totally consistent, this can be due to the holding of an opposite position in the futures markets.
As such it is possible that uncertainty about the future price of the underlying transaction is completely eliminated. As a result of a parallel movement in forward prices on the spot prices of a market subject to capital gains and losses from the same, therefore, ideally perpetual.
A distinction between stocks hedging and anticipatory hedging is that a stock hedge is used to hedge an existing cash position, eg a DAX portfolio. The anticipatory hedge would receive a purchase of the DAX at a future date.
Hedging reduces the risk of a financial transaction but also comes with additional costs. There is always a compromise between expected return and acceptable risk. Generally, hedging is not useful if the additional hedging costs are higher than the expected return from the hedged financial transaction.
In addition, the securing of transactions on the futures markets is a complex process for beginners and is subject to additional risks. There are many examples from the past in this regard which originated from misunderstanding of received hedging positions in oil futures.
An alternative to hedging may reduce the volatility of an investment portfolio through diversification. On the other hand, hedging transactions can deceive others to inflate circulations in the financial markets.