In financial terms, the dictionary definition of “to hedge” is: To initiate transactions that are protected to reasonable magnitudes against loss by using instruments that will make inverse price movements. Hedging is a means of preventing complete — or at least large — losses of a position through the use of a counterbalancing position.
If today’s hedge funds have been using reasonable mechanisms and tools to hedge, why are so many hedge funds failing? And why are so many hedge funds failing to such a large extent as to force them into liquidation?
Logical answers include, 1.) They did not understand how to effectively hedge many positions, 2.) They failed to put hedges on many positions in order to cut costs, or 3.) They used the regulatory title of “hedge fund” so that they could take on extraordinary margin debt, thus executing highly leveraged positions.
In any case, many hedge funds held on too long out of arrogance and failure to envision the potential magnitude of today’s credit clutch.