A hedge is an investment used to reduce an individual or entity’s risk of exposure to adverse price movements. It is an insurance policy that protects an investor against the downside risk associated with an investment in a particular security.
A car manufacturer may hedge its exposure to fluctuations in the price of steel by purchasing a futures contract that will allow it to purchase steel at a fixed price over a specific period of time. This is attractive to the car manufacturer because it is able to project a stable budget over this period of time and reduce its exposure to a spike in the price of steel, which would result in a spike in its cost of production of a vehicle.
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