What is the purpose of a hedge in securities trading?

What is the purpose of a hedge in securities trading?

• A. To maximize profits without risk
• B. To reduce the risk of adverse price movements
• C. To outright sell off assets
• D. To ensure liquidity

Answer: (B)

The purpose of a hedge in securities trading is primarily to reduce the risk of adverse price movements. Hedging involves taking an offsetting position in a related asset or financial instrument to protect against potential losses in one's primary investment. For example, if an investor holds a stock that they believe might decrease in value, they could purchase a put option for that stock, which would increase in value as the stock’s price falls. This strategy helps to mitigate the potential financial impact of the unfavorable price movement.

In contrast, maximizing profits without risk is unrealistic in trading, as all investments carry some level of risk. Selling off assets outright does not necessarily involve hedging and could expose an investor to greater price volatility. Ensuring liquidity is more about being able to quickly buy or sell assets without drastically impacting the price rather than directly related to the concept of hedging risk. Therefore, the focus on reducing adverse price movement is central to the definition of hedging.