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Hedging Strategy

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Hedging Strategy. How to use money market hedging and financial hedging to your advantage and make money off it.

Financial Hedging

In investment analysis, Billingsley defined a hedging transaction in this way: a hedging transaction is intended to reduce or eliminate the risk of a primary or preexisting security or portfolio position. An investor consequently establishes a secondary position to counterbalance some or all of the risk of the primary investment position.

Money Market Hedging

Thus, an equity mutual fund manager would not completing get out of equities if the market is expected to fall, but instead seek to partially offset the risk on the investment by taking short positions in selected equities, buying or selling derivatives, or some combination thereof.

Substitute for Preferred Action

Another interesting way to view hedging is that it is a substitute for the investor’s preferred action. As Billingsley notes, a hedging transaction could be a substitute for the investor’s preferred action in the absence of constraints that interfere with taking that action. Possible constraints include:

  • Self-Imposed Risk Tolerance Constraint – the investor might want to keep a stock with a profit, but feels compelled to offset all or part of the position’s risk by using a hedging transaction, perhaps for tax purposes.
  • Portfolio Policy Requirements – perhaps that an investor maintain a given percentage of funds invested in a stock (as is the case for some trust funds)
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