In finance, what is hedging and why do investors and companies use hedging strategies?

Introduction / Context:
Hedging is a core concept in risk management and modern finance. When investors, companies or even banks talk about managing market risk, interest rate risk or currency risk, they are often referring to hedging strategies. Understanding what hedging is, and why it is used, helps candidates in finance interviews show that they grasp how real world portfolios and corporate exposures are protected from volatility and unexpected price movements.

Given Data / Assumptions:

• An investor or company already has an existing exposure, such as owning shares, holding commodities, or receiving cash flows in a foreign currency.
• Market prices, interest rates or exchange rates can move in unfavourable directions in the future.
• The goal is to reduce potential losses from those adverse movements, not necessarily to maximise profit from speculation.
• Financial instruments such as futures, options, forwards and swaps are available to construct hedges.

Concept / Approach:
Hedging means taking an additional financial position that is designed to move in the opposite direction to the risk you are exposed to. If the price of the original asset falls, the hedge position should gain, and vice versa. In practice, investors and firms use derivatives or offsetting cash positions to partially or fully neutralise risk. The main purpose is risk reduction or stabilising cash flows, not earning extra speculative profit. Hedging can be simple, like buying insurance on a house, or complex, like using currency swaps to manage foreign exchange risk in international projects.

Step-by-Step Solution:
Step 1: Identify the existing exposure, for example owning 1,000 shares of a company, holding an oil inventory, or expecting to receive US dollars in three months. Step 2: Analyse which market variable creates risk, such as share price volatility, commodity price fluctuations or exchange rate movements. Step 3: Select a hedging instrument whose value tends to move opposite to that risk, for example a futures contract, an option, a forward contract or a swap. Step 4: Enter into the hedging position in a size that is appropriate for the underlying exposure, aiming to reduce, not necessarily eliminate, potential losses. Step 5: Monitor both the original exposure and the hedge over time, adjusting positions if the risk profile or business needs change.

Verification / Alternative check:
Consider an airline that will need large quantities of jet fuel over the next year. If fuel prices rise sharply, its costs increase and profits fall. To hedge, the airline can lock in fuel prices using futures contracts or long term supply agreements. If market prices rise, the futures contracts gain value and offset the higher physical cost. If prices fall, the company pays more than the new spot price, but it has gained stability and avoided the worst case scenario. This example shows that hedging is about managing downside risk rather than beating the market.

Why Other Options Are Wrong:
Option B confuses hedging with aggressive borrowing and speculation, which actually increases risk. Option C describes risk avoidance by holding only cash, which is not realistic for most investors and does not match the technical meaning of hedging. Option D suggests ignoring risk entirely, which is opposite to the goal of hedging. Option E describes a narrow trading pattern, not a structured risk offset. None of these capture the essence of using offsetting financial positions to reduce the impact of adverse price movements.

Common Pitfalls:
People sometimes think hedging guarantees profits or completely eliminates risk, which is not true. Hedges can be imperfect, may involve costs such as option premiums and can limit upside potential. Another common mistake is treating any derivative trade as a hedge, even when there is no underlying exposure to protect. In interviews and exams, emphasise that hedging starts with an existing risk and uses offsetting positions to manage, not magnify, that risk. This balanced understanding reflects how hedging works in practice.

Final Answer:
Hedging is using one or more financial positions, such as derivatives or offsetting assets, to reduce or limit the risk of adverse price movements in an existing exposure.