Hedging in Finance: Definition & Example

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

When individuals and institutions have investments in the stock market, they are exposed to the risk of financial losses. In this lesson, we'll learn about a way to protect against some losses, known in the financial industry as hedging.

What Is Hedging?

Anytime you take a personal risk - even something as simple as driving a car, buying the warranty on a new computer purchase, or bungee jumping - you hedge your risk. You may not call it that, but when you do something to mitigate the risk associated with an event, you are hedging.

Wearing a seat belt when you drive a car hedges against the risk of injury if you are in an accident. Buying a warranty for a new computer hedges against the risk of the new computer having issues for some time. The safety line buckled onto your harness when you bungee jump hedges against the unfortunate results that would occur if your main line broke!

When you understand hedging in a personal context, you can start to understand how hedging is important to an individual or institutional investor. With money at risk, any opportunity to mitigate risk is typically welcomed.

Hedging in the Financial Markets

While hedging can refer to anything that has a risk to mitigate, it is most commonly used in the financial markets. There are a number of different hedging strategies, each requiring a different financial instrument and each mitigating a different degree of risk. To explain this further, we'll go through an example and discuss how these strategies work and offset some of the risk of the primary investment.

One common strategy of hedging is to short a stock that is very similar to the stock you are purchasing. When you short a stock, you actually make money when the price of the stock goes down. So, if you want to by 100 shares of an airline, with the ticker XYZ at a cost of $50 per share, it would cost you $5,000. But, you are completely exposed to the risk associated with that stock.

However, if you also went short 25 shares of another airline, perhaps XYZ's competitor ABC at $100 per share, you have hedged some of your risk. If the price of oil increases quickly, increasing the cost of fuel for airlines, the stock price for airlines would go down.

To see the impact of hedging, let's say the increase in the cost of fuel led to a decrease in airline stock prices of 10%. Of course, not all airlines would see the same decrease, but to keep the math simple - let's assume. Your original investment of 100 shares at $50 per share would decrease from a value of $5,000 to $4,500 - a loss of $500.

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