Hedging
Hedging is taking a position that gains when an existing exposure loses, so that a move in a price, rate or currency leaves the combined result roughly unchanged. A hedge reduces uncertainty; it does not guarantee a profit or rule out a loss.
Also called: hedge · FX hedging · currency hedging · risk hedging
A hedge starts from an exposure that already exists: a receivable or payable in a foreign currency, a floating-rate loan, inventory whose price can fall. The hedge is a second position that moves the opposite way. The common tools are a forward contract, a futures contract, an option and an interest rate swap. A natural hedge achieves the same by matching the currency of costs and revenues without any contract at all.
The line between hedging and speculation is the size of the position relative to the exposure. A firm that sells forward 100 percent of a confirmed foreign-currency receivable has hedged it. A firm that sells 150 percent has hedged the receivable and opened a separate bet with the other half, and a hedge against a forecast flow that never arrives becomes a bet in the same way. The instrument is identical in each case; only its relationship to the underlying changes.
Hedging has costs: forward points, option premiums, bank credit lines and the cash needed for margin calls when the hedge moves against the firm before the underlying gain arrives. For a payments or remittance business, the exposure is usually the gap between collecting funds in one currency and paying out in another. A common policy hedges committed flows in full and forecast flows only in part.
In practice
A hedge that works on paper can fail through basis risk, when the instrument does not track the exposure closely; through timing mismatch; or through the failure of the counterparty on the other side.
Example
A UK firm will receive US$2 million in 90 days and sells it forward at 1.27 dollars per pound, locking in about £1,574,800. If the rate moves to 1.35, the unhedged amount would have been about £1,481,500, so the hedge protected roughly £93,300. If it moves to 1.20, the unhedged amount would have been about £1,666,700, and the hedge gave up roughly £91,900 of upside.
Learn more on Money Wiki
This page gives the short answer. Money Wiki has a longer guide to Hedging, with more detail and background.
Commonly confused with
| Term | How it differs |
|---|---|
| Speculation | Speculation takes on risk in the hope of a gain. Hedging offsets a risk the firm already has. The same contract can be either, depending on whether an exposure stands behind it. |
See also
- Natural HedgeA natural hedge reduces currency exposure by matching receipts and payments in the same currency. For example, a company receiving RMB may use those funds for RMB supplier obligations instead of converting twice.
- Forward ContractA forward contract is an agreement to exchange one currency for another on a future date at a rate fixed today. It creates a binding obligation on both sides — which is what makes it useful for certainty and dangerous if the underlying payment never happens.
- Options ContractAn options contract gives its buyer the right, but not the obligation, to buy (a call) or sell (a put) an asset at a set strike price on or before an expiry date. The buyer pays a premium; the seller, or writer, takes on the obligation.
- DerivativeA derivative is a contract whose value comes from the price, rate or event it references, called the underlying. It lets parties take on or shed exposure to that underlying without buying or selling the underlying itself.
- Margin CallA margin call is a demand that a party to a leveraged position or derivative post more collateral, usually cash, because the position has moved against it or the required margin has risen. If the call is not met, the counterparty can close the position.
- FX SwapAn FX swap is a contract in which two parties exchange two currencies today and agree to reverse the exchange on a set future date at a rate fixed now. In economic terms it is a loan of one currency secured by another.