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What are Insuring and Hedging (Comparison)

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There is a fundamental difference between insuring and hedging. When you hedge, you eliminate the risk of loss by giving up the potential for gain. When you insure, you pay a premium to eliminate the risk of loss and retain the potential for gain.

Let us return to an earlier example to clarify the difference between insuring and hedging. You are planning a trip from Boston to Tokyo a year from now. You make your flight reservations now, and the airline reservation clerk tells you that you can either lock in a price of $1,000 now, or you can pay whatever the price turns out be on the day of your flight. If you decide to lock in the $1,000 price, you have hedged against the risk of loss. It costs you nothing to do so, but you have given up the possibility of paying less than $1,000 for your flight a year from now.

Alternatively, the airline may offer you the possibility of paying $20 now for the right to purchase your ticket a year from now at a price of $1,000. By buying this right you have insured that you will pay no more than $1,000 to fly to Tokyo. If the price should turn out to be more than $1,000 a year from now,you will exercise this right; otherwise you will let it expire. By paying $20 you have purchased insurance against the risk that you will have to pay more than $1,000 for the ticket and, thus, you have insured that the total cost to you will not exceed $1,020 ($1,000 for the ticket plus $20 for the insurance).

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