What is Hedging in Finance?

Hedging is a risk reduction technique whereby an entity uses a derivative or similar instrument to offset future changes in the fair value or cash flows of an asset or liability. A perfect hedge eliminates the risk of a subsequent price movement. A hedged item can be any of the following individually or in a group with similar risk characteristics:

Highly probable forecast transaction
Net investment in a foreign operation
Recognized asset
Recognized liability
Unrecognized firm commitment

Hedge effectiveness is the amount of changes in the fair value or cash flows of a hedged item that are offset by changes in the fair value or cash flows of a hedging instrument.

Examples of Hedging Instruments

Here are several common examples of hedging instruments:

Forward contract. A contract between two parties to buy or sell an asset at a specified price on a future date.
Futures contract. A standardized contract that is traded on an exchange, to buy or sell an asset at a predetermined price at a specific future date.
Option. A financial derivative that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price before or on a specific date.
Swap. A contract to exchange cash flows or financial instruments between two parties. Examples are interest rate swaps and currency swaps.
Short selling. This involves selling a borrowed asset with the expectation that its price will decline, allowing it to be repurchased later at a lower price. It is a hedge against potential losses in a long position.

These instruments are chosen based on the nature of the risk, the specific market, and the user’s risk tolerance.

Accounting for Hedges

Hedge accounting involves matching a derivative instrument to a hedged item, and then recognizing gains and losses from both items in the same period. The net result of these gains and losses should be relatively small, as long as the hedging instrument was properly paired with the hedged item.