In this regard hedging can be assessed as some sort of an insurance against damaging events as a consequence of which loss is minimized. Investors must use advanced strategies to find instruments to offset the risk of unexpected price movements. This requires investing in different alternatives that are negatively correlated.
Negative correlation implies that the movements of two investments will be in opposite directions, at the expense of sacrificing the opportunity cost of getting the higher return with assuming higher risk.
A desire for greater profit is always associated with greater risk. Therefore, hedging can be considered as a diversification of risk among alternative investment opportunities. The framework of the risk–return tradeoff draws the borderline for hedging attempts.
Apparently, the risk is reduced by hedging but this further adds to the potential of higher profit. Risks to be avoided through hedging can be due to interest rate, equity, credit, or currency.
Initial opinions about hedging can be traced back to Marshall (1919) who expressed that hedging is not speculation but insurance. Keynes (1930), the founder of the economics school of thought known by his name, also stated that hedging is used as a means for avoiding risk.
Stein (1961) realized that hedging was a way of maximizing expected utility out of the assets owned in the framework of the portfolio theory. Kamara (1982) contributed to the theory by claiming that the main purpose in hedging is the desire to stabilize income and increase expected profits.
The most remarkable hedging practice was by Alfred Winslow Jones, who introduced the first hedge fund in 1949. Jones established an investment fund that would offset long positions in undervalued equities by short positions and used leverage since the capital he could invest was limited.
It is interesting to note that the words “hedge funds” are derived from the word “hedging” and are supposed to manage and decrease risk but they assume a greater amount of risk than the market with strategies such as short selling, leveraging, and arbitrage.
As a consequence of failure in managing risk successfully, history has witnessed collapses of hedge funds in the late 1990s and early 2000s. Hedging used by firms have become more complicated and sophisticated as modern markets are subject to risks from numerous sources as a consequence of globalization.