Hedging is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment. The market supply-and-demand dynamics creates unprecedented volatility in the asset prices, thus exposing investors to the downside risk. In an attempt to manage this volatility many investors use hedging as a strategy. Portfolio managers, investors and corporations use hedging strategies to limit risk and curtail potential losses, but with reduced risk comes reduced returns. In designing hedging strategies, investors can choose from a variety of tools, including stocks, exchange-traded funds, insurance and various derivative products.
Employing an effective hedging strategy does not mean eliminating the risk completely, but rather it tries to differentiate acceptable and unacceptable risks and transform the risk that is unacceptable. However, determining the risk that the company is willing to bear and one that needs to be transformed is a challenge in itself. Main purpose of a hedging strategy should be to achieve an optimal risk profile for the company that ultimately creates a balance between the benefits and costs of hedging.