Glossary term
Hedging
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Also known as: Risk hedging
Hedging means taking a second position chosen to gain when an existing exposure loses, so the two largely cancel out.
Explanation
A hedge reduces uncertainty rather than creating profit. A firm worried about a rise in the price of a commodity it must buy can lock in a price with a forward or futures contract. A bank can swap a floating-rate loan into a fixed rate, and an exporter can sell foreign currency forward. Instruments include forwards, futures, options and swaps, and natural hedges arise from business choices, such as borrowing in the same currency as revenue. Hedging has a cost, in fees, margin or given-up gains, and it is rarely perfect because of basis risk. Poorly controlled hedging can turn into speculation, so firms set a policy on what can be hedged, by whom and to what level, and report the results. Budget owners use it to fix costs or income in advance so plans survive a price move.
Example
An airline expects to buy fuel worth 50 million over the next year. It fixes the price for 60% of that volume with swaps. If fuel prices rise 20%, the airline pays more in the market but receives payments on the swaps for the hedged part. If prices fall, it loses on the swaps. Either way, the price of the hedged 60% is known in advance.
Not to be confused with
- Speculation
- Speculation takes on risk in the hope of profit. Hedging takes a position to cut an existing risk.