Hedging is a technique to reduce exposure to risk in financial transactions. The correct hedging tools depend on the assets or transactions involved, and can include futures, options, and forwards. Hedging tools involve costs, but can remove uncertainty and allow for smooth trades.
Hedging is a technique for reducing exposure to measurable types of risk in financial market transactions. It’s a type of insurance, and while it can’t eliminate risk entirely, coverage can mitigate the effect. The correct hedging tools will depend on the types of assets or transactions involved. For example, for a portfolio that contains 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 forwards, either 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. 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 particular price, or a put option to sell at a particular price at a future date. Unlike futures, the owner of the option is not required to enter into the transaction if the market price is more advantageous than the option price.
Hedging currency risk can be done with forwards, 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 the local currency, or when purchasing supplies or equipment abroad. Forward contracts are unique to the foreign exchange market and allow a company or investor to lock in a specific transaction to exchange one currency for another on a certain date.
Unlike futures contracts, a currency forward contract is not standardized or tradable, and if one party defaults, the other party is out of luck. Futures contracts represent a less risky alternative to hedging against currency market fluctuations. Depending on the direction and amount of volatility in the forex market, the company will choose futures or options, or a combination 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 off the yen-denominated debt when the Japanese company pays for the products. This allows the French company to fix the current exchange rate between the euro and the yen. The cost is the interest rate of the yen loan, which may be less than the cost of another hedging tool.
A common use of futures as a hedging tool is when a company relies on a certain commodity to produce its products, such as coffee beans. To hedge against adverse movements in the price of coffee beans, the company may choose to purchase coffee futures and lock in a particular price. The company must make the purchase, even if the market price of the coffee is less than the contracted price. This is a risk to use futures as a hedging tool, unless the cost of price uncertainty is greater than the cost of paying above market price and, where 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 in the risk and the associated cost if the choice of the hedging instrument results in higher costs than those of the market of the underlying asset. Therefore, the use of hedging tools reduces both the total risk and the return of the underlying asset or business. For corporations, however, the value of hedging against currency or commodity market fluctuations is to remove uncertainty. This can allow for smooth trades and the ability to keep prices consistent, which can outweigh the cost of the hedging strategy.
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