The salaries and bonuses of hedge fund managers often make the headlines. You’ve probably heard the term ‘hedge your bets’ too. But, in reality, financial hedges are more like an insurance policy.
Investors use hedges in the same way that a homeowner might insure against flooding. It costs you a set amount of money to insure the risk, but when you weigh this up against the potential cost of a flood, you’re happy to pay the insurance. You know what your maximum loss will be, the price of the insurance plus any excess.
Hedges can be used in wide range of situations to try to limit risk. For example, an exporter can hedge against currency fluctuations by agreeing a future price for currency now.
Hedges protect you from risking more losses, but they also limit your potential profit. Just like insurance, because your house may never get flooded, so you could have paid those insurance premiums for nothing.
A hedge fund builds a strategy about the way markets will perform into a collective investment across a range of assets. They’re usually only used by sophisticated investors.