Hedging is a risk management mechanism whereby downside risk is minimized by locking in the position. In trading and investing, hedging means fixing the price of underlying asset as per buying and selling exposure against the price uncertainty. Hedging is also about striking a balance between uncertainty and the risk of opportunity loss.
The word hedge means protection. A hedge is an investment to reduce the risk of adverse price movements in an asset. Assets may include foreign exchange rates, interest rates, commodity prices, and equity prices. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
The person or institution that does hedging is called hedger. Example producers, manufacturers, exporters, importers, investors etc.
Example of hedging:
A farmer who has standing crop of basmati paddy would like to sell the crop in advance. Suppose in the month of August or September, the farmer sees the basmati paddy futures price for October contract and find the price favorable to sell. So he sells the October futures basmati paddy contract through broker and delivers the material in the exchange designated warehouse before contract expiry, let’s say in September last week. The contract settles on 5th of October and he will get the payment by 7th of October. Delivery process and final settlement usually completed within 5 to 7 days. Similarly a basmati exporter who requires paddy to make rice for export down the line in the month of October. He will buy basmati paddy futures contract at ICEX for October delivery by paying a small margin amount of only 5-10%. Upon contract settlement in the month of October he will make the payment to get the delivery.