Hedging is a process used by investors to protect themselves from any unfavorable events in the future. In general hedging is strategy that is incorporated to protect your investment in the stock market and increase the gains. For hedging, a person or an entity needs another entity to enter into the strategy; these other parties are known as counter parties. There are different ways to hedge an investment, however they all consist of agreements between you and the third party.
Difference between Insurance and Hedging
Insurance is a promise of compensation for specific potential future losses in exchange for a periodic payment. Insurance is designed to protect the financial well-being of an individual, company or other entity in the case of unexpected loss.
Hedging is a bit like insurance. The share buyer takes out the insurance of having a put option. It means he can’t lose more than 20%. The speculator hopes to make profit from the fact the chance of share prices falling is very low.
Hedging can be implemented in a variety of ways including stocks, exchange-traded funds, and insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.
Hedging and insurance are risk-reduction strategies. When you buy an insurance policy, you pay a premium to avoid risk while not limiting your potential rewards. Hedging, on the other hand, is a financial strategy that involves giving up potential financial gain to avoid financial risk.
Example of hedging:
Assume you are a farmer and you have a crop of corn that will be ready for harvest in two months. A buyer offers to pay you 5 bucks per bushel when your harvest is ready. If you agree to accept the offer, you lock in the price and you are guaranteed to earn at least 5 bucks per bushel regardless of what the market price is when your harvest is ready. In this case, you are hedged against a future price drop below 5 bucks. However, your hedge also limits your earnings to 5 bucks even if the price of corn is selling for more than this amount when your harvest is ready.
Example of Insurance:
Now assume instead of offering you 5 bucks per bushel of corn today, a buyer offers you a contract that gives you the right, but not the obligation, to sell your corn for 5 bucks a bushel when it is ready for harvest. For this right, the buyer charges you 200 bucks. In this case, you are insured against a future price drop below 5 bucks per bushel. However, if the market price for corn is higher than 5 bucks when your crop is ready for harvest, you can sell it for the higher price; thus, you insured yourself against downside risk without limiting your potential profits.
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