Hedging is a technique for reducing exposure to measurable types of risk in financial market transactions.
Hedging is a technique for reducing exposure to measurable types of risk in financial market transactions. It is a type of insurance, and while it cannot completely eliminate the risk, hedging can mitigate the effect. The correct hedging tools will depend on the types of assets or transactions involved. For example, for a portfolio containing international investments, it would be prudent to hedge against unexpected currency movements in order to preserve the value of the portfolio in the local currency. The main types of hedging tools include futures, options and futures – whether on one of the underlying assets in the portfolio, on a currency index or on an asset negatively correlated with the portfolio.
Futures are an agreement to buy a commodity or currency on a specific date at a specific price.
Futures are an agreement to buy a commodity or currency on a specific date at a specific price. Options are a more flexible hedging tool. A company or investor can buy a ‘call’ option, which is the right to buy an asset at a certain price, or a ‘put’ option, to sell at a certain price at a future date. Unlike futures, the option owner is not obligated to proceed with the transaction if the market price is more advantageous than the option price.
Hedging currency risk can be done with forward, futures or options contracts. For a company with international operations, the use of currency hedging tools is very important when converting profits from foreign operations into national currency or when purchasing inputs or equipment abroad. Forward contracts are unique to the foreign exchange market and allow a company or investor to close a specific transaction to exchange one currency for another on a specific date.
Unlike futures contracts, a currency forward contract is not standardized or tradable, and if one party defaults, the other party is completely out of luck. Futures contracts represent a less risky alternative to hedge against foreign exchange market fluctuations. Depending on the direction and amount of volatility in the currency market, the company will choose either futures or options – or a mix of both – depending on the specific currencies involved.
A money market hedge is another type of hedging tool for a future foreign currency transaction. For example, if a French company wants to sell equipment to Japan, it can borrow in yen now and pay the yen-denominated debt when the Japanese company pays for the products. This allows the French company to lock in the current exchange rate between the euro and the yen. The cost is the interest rate of the loan in yen, which may be less than the cost of another hedging tool.
A common use of futures as a hedging tool is when a company depends on a particular commodity to produce its products, such as coffee beans. To protect against adverse movements in the price of coffee beans, the company may choose to buy coffee futures and lock in a certain price. The company is obliged to make the purchase, even if the market price of the coffee is lower than the contracted price. This is a risk of using futures as a hedging tool unless the cost of price uncertainty is greater than the cost of paying above market price and, when possible, options present a more flexible hedging solution.
All hedging tools and techniques involve various costs. The first is the cost of the hedging instrument itself. The second on the associated risk and cost if the choice of hedging instrument results in higher-than-market costs of the underlying asset. Therefore, the use of hedging tools reduces the overall risk and return of the underlying asset or business. For companies, however, the value of hedging against currency or commodity market fluctuations is to eliminate uncertainty. This can allow for smooth trading and the ability to keep prices consistent, which can far outweigh the cost of the hedging strategy.