Legal Definitions - hedge

To hedge means to take a protective action to reduce or offset the risk of potential financial loss on an existing investment, transaction, or future commitment. It involves making a separate, often opposing, arrangement designed to limit exposure to unfavorable market movements or unforeseen events.

• Example 1: Protecting against currency fluctuations

  A U.S. technology company sells its software to a client in Japan and expects to receive a payment of 100 million Japanese Yen in three months. The company is concerned that the Yen might weaken against the U.S. Dollar by the time they receive the payment, which would reduce the dollar value of their earnings. To hedge this risk, the company enters into a forward contract with a bank to sell 100 million Yen at a predetermined exchange rate three months from now.

  This illustrates hedging because the company is taking a specific action (the forward contract) to lock in an exchange rate, thereby protecting itself from the potential loss of revenue if the Japanese Yen depreciates against the U.S. Dollar before the payment is received.

• Example 2: Managing interest rate risk

  A real estate developer takes out a large, variable-rate loan to finance a new construction project. While current interest rates are low, the developer is worried that rates might significantly increase over the next few years, making their loan payments much higher and potentially jeopardizing the project's profitability. To hedge against this, the developer purchases an interest rate cap from a financial institution.

  This is an example of hedging because the interest rate cap sets a maximum interest rate the developer will have to pay, regardless of how high market rates climb. This arrangement protects the developer from the financial risk of rising interest rates, ensuring their loan payments remain within a manageable range.

• Example 3: Safeguarding an investment portfolio

  An individual investor holds a substantial portion of their retirement savings in stocks of a particular industry that has seen rapid growth. While they believe in the long-term potential of these companies, they anticipate a possible short-term market correction or downturn specific to that industry. To hedge their portfolio, the investor decides to buy "put options" on an exchange-traded fund (ETF) that tracks the performance of that same industry.

  This demonstrates hedging because the put options give the investor the right to sell the ETF at a predetermined price, even if the market value falls. If the industry experiences a downturn, the value of the put options will increase, offsetting some of the losses from their stock holdings and protecting a portion of their investment without requiring them to sell their actual stocks.