Financial hedging is where a company or an investor looks to reduce or eliminate their exposure to an asset they already own. This can be done by taking an equal and opposite position using futures contracts. An owner of silver for instance, fearing a price drop ahead, could sell futures contracts which will rise in value if silver falls. That profit offsets the loss, creating the ‘hedge’.
The main use of hedging is by commercial businesses involved in the production of a raw material or product. In the gold mining industry, so-called ‘producer hedging’ became increasingly popular during the long price drop of the 1980s and ’90s. Fearing further price drops ahead, which would result in lower revenues for gold miners, the industry as a whole borrowed and sold 3,100 tonnes of gold by 2001 – then equal to 15 months of the world’s entire gold-miner production. That locked in current prices, with the gold loan ready to be paid back as the miner dug gold from the ground in future. Some miners became over-hedged however, losing money when the gold price then began to rise. The industry started to close its hedging positions, buying back the metal it had sold at rising prices. The gold miners’ hedge-book was effectively closed in early 2011, as prices rose to new all-time highs.
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