The Idea
A hedge is a position taken to offset the risk of another position. If a US company will receive €1m in 90 days, it can sell EUR futures now to lock in the exchange rate.
Common Hedgers
- Airlines hedging jet fuel
- Farmers hedging crop prices
- Miners hedging metals
- Portfolio managers hedging equity risk with index futures
Perfect vs Imperfect Hedge
A perfect hedge fully offsets the underlying risk. In practice, most hedges are imperfect due to timing, contract size and basis risk.
Cost of Hedging
- Margin required
- Opportunity cost if the underlying moves favourably
- Rollover cost as futures expire
Key Takeaways
- Hedging is about risk management, not profit.
- It transfers price risk to speculators.
- All hedgers should model the impact of imperfect matching.