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 may not eliminate the risk completely, hedging can mitigate its effect.
The correct hedging instruments will depend on the types of business 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 domestic currency. The main types of hedging instruments include futures, options and forwards, whether on an underlying asset in the portfolio, in a currency index or on an asset that is negatively correlated with the portfolio.
Futures are an agreement to purchase a product or currency on a specific date at a specific price.
Options are a more flexible hedging tool. A company or investor may purchase a “call” option, which is the right to buy an asset at a particular price, or a “put” option, to sell at a specified price at a future date. Unlike futures, the option holder is not required to complete the transaction if the market price is more advantageous than the option price.
The exchange risk can be hedged with forward contracts, futures or options. For a company with international operations, the use of currency hedging instruments is very important when converting profits from foreign operations into the domestic currency or buying inputs or equipment overseas. Forward contracts are exclusive to the foreign exchange market and allow a company or investor to block a specific transaction to exchange one currency for another on a particular date.
Unlike futures contracts, a forward currency contract is not standardized or negotiable and if one party fails, the other party is completely out of luck. Futures contracts are a less risky alternative to hedging against currency market fluctuations. Depending on the direction and amount of volatility in the currency market, the company will choose futures or options, or a mix of both, depending on the specific currencies involved.
A money market hedge is another type of hedging instrument 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 off 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. Cost is the interest rate on the loan in yen, which may be less than the cost of another hedging instrument.
A common use of futures as a hedging instrument is when a company depends on a certain commodity to produce its products, such as coffee beans. To protect itself from negative movements in the price of coffee beans, the company can choose to buy coffee futures and set a particular price. The company is required to make the purchase, even if the market price of the coffee is lower than the contracted price. This poses a risk to using futures as a hedging instrument, unless the cost of price uncertainty is greater than the cost of payment above the market price and, where possible, the options present a solution to more flexible coverage.
All hedging instruments and techniques involve different costs. The first is the cost of the hedging instrument itself. The second in the risk and associated cost if the choice of the hedging instrument involves costs higher than the market for the underlying asset. Therefore, the use of hedging instruments reduces both the total risk and the return on the underlying asset or asset. For companies, however, the value of hedging against fluctuations in the currency or commodity market is to eliminate uncertainty. This can allow for smooth transactions and the ability to keep prices consistent, which can far outweigh the cost of the hedging strategy.