Hedging

What is hedging?

Hedging involves taking a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change; or a purchase or sale of futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future). (Source: CFTC)

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger doesn't care whether the market as a whole goes up or down in value, only whether the under-priced security appreciates relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the security's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency.

Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, (for example) revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar, and could choose to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.

Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but face costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.

Currency hedging is used both by financial investors to parse out the risks they encounter when investing overseas, as well as by non-financial actors in the global economy for whom multi-currency activities is a necessary evil rather than a desired state of exposure.

For example, cost of labor variables dictate that much of the simple commoditized manufacturing in the global economy today goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of never having done business in foreign countries, so many businesses are jumping into the fray and becoming part of the globalization trend of moving manufacturing operations overseas. The benefits of doing this however, come with numerous risks that were never a problem when manufacturing was done at home--among them currency risk.

If your cost of manufacturing goods in another country is denominated in a currency other than the one that you sell the finished goods in, there is the risk that the currency "volatility" alone may destroy the margin between what you pay to produce your product, and what you collect when you sell it (note you may be selling your product in a foreign country too, so you can hedge against the currency risk on this side as well!). So when you convert all costs on the production side, and all sales receipts from the retail side, back into your home currency, you may be alarmed to find that your profits have diminished significantly, or disappeared altogether. That's currency risk-- it is germane to doing business globally, but entirely independent of your specific business or products. Currency hedging then, is the insurance you can purchase to limit the impact this unpredictable risk has on your business, the same way Fire or Hurricane insurance protects your physical premises from unexpected events beyond your control.

Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity. The currencies beyond the Major 8 can most reliably be identified by checking to see which are included within the "Continuous-Linked Settlement Bank" "(CLS Bank)", which handles a growing percentage of the globe's daily settlement volume between currencies.

Currency hedging, like many other forms of financial hedging, can be done in two primary ways, with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

The financial investor application may be that a hedge fund (let's say, based in New York) finds a great company to invest in, but doesn't want to necessarily be investing in the currency of the country this company resides in (let's say, Brazil for example). So, the hedge fund can separate out the credit risk (eg the Company, which it wants to take a position in), from the currency risk (eg the Brazilian Real, which it doesn't want to take a position in) by "hedging" out the currency risk. In effect, this means that the investment the hedge fund makes into the company is effectively a USD investment, in Brazil. Hedging product allows the investor to transfer the currency risk to someone else who does want to take a position in the currency. The New York based hedge fund has to pay this other investor to take on the currency exposure, the same way you pay any insurance company to provide insurance against an unknown outcome. The "gamble" the insurance provider takes is that the ultimate outcome during the period insured will not exceed the amount the buyer paid; the insurance provider may, however, be hedging their own risk on a similar (mirror image) transaction. In this way, the global economy becomes more efficient, because two investors are able to take positions they both want. (Source: Wikipedia)

See also:
Hedge Fund