Difference between Arbitrage and Hedging

Arbitrage and hedging are two of the most extensively used techniques which help the investor to manage their funds more prudently. Both the terms are quite different to each other. In arbitrage, the investor aims to earn profit from the difference of the market values of an asset whereas in hedging, he targets to reduce the loss which he expects to face in the future.

The investors can learn a lot about arbitrage and hedging by studying the subject of financial management. However, the techniques of arbitrage are more profound as compared to hedging.

Instructions

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    Arbitrage

    In finance or economics, arbitrage is known as a practice of the investors in which they seek to earn profits from the differences in the markets values of an asset. It is a risk-free profit which is earned by the investors at zero cost. In principle and in academics, there is no involvement of negative cash flow and the investor expects a profit from the activity. However, in practice, there may be a loss from the activity of arbitrage as the expected market value of an asset can change because of some economical, political and social factor in the state.

    Arbitrage is mostly practiced in the cash equivalents like shares and other marketable securities (derivatives, currencies or bonds). But, it can also be practiced in a merger. Furthermore, the person who is involved in arbitrage is known as arbitrageur.

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    Hedging

    It is an investment position in which an investor tries to compensate potential loss or gains which may occur due to any other investment. It is simply a situation in which the investor intends to reduce his loss which he expects to suffer in the near future.

    Hedging can be done with many different kinds of financial instruments which mainly include stocks, swaps, options, forward contracts, insurance, exchange-traded funds, derivatives, future contracts and over-the counter products. Most of the hedging takes place in future contracts related to the fields of energy, precious metals, interest rates and foreign currency fluctuations. At first, the hedging activities were conducted freely without any kind of control, but with the passage of time many organisations were established which handle the investors’ affairs related to hedging.

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