What is Portfolio Hedging?
Portfolio hedging describes a variety of techniques used by investment managers, individual investors and corporations to reduce risk exposure in an investment portfolio. Hedging uses one investment to minimize the negative impact of adverse price swings in another.
How Portfolio Hedging Works
Portfolio hedging typically entails the use of financial derivatives (options and futures) to curtail losses. For example, an investor worried about short-term price swings in ABC stock can hedge their stock portfolio against short-term losses by purchasing the same number of ABC put options. A decline in the value of ABC shares will be hedged, or offset, by profits from the put options.
There are a wide assortment of options and futures contracts that an investor can hedge against nearly every type of risk. For example, hedges can be created to protect a portfolio from stock and commodity price movements, interest rate changes and currency swings.
Why Portfolio Hedging Matters
The purpose of portfolio hedging is to curtail potential losses. This safety also comes at a price, since hedging also limits potential profits. Every hedge has a cost, so investors should weigh the costs of the hedge against its benefits. For most buy-and-hold investors, hedging is unnecessary, since short-term price swings in a portfolio won’t matter.