What is Hedging?

Helping You Mitigate Your Financial Risk with hedging

You have probably heard that global inflation and interest rates are reaching multi-decade highs, which might lead you to ask, so what? Well, the result of these dynamics is a surging dollar. Revenues coming from other countries are depreciating with their currency, and many multinational corporations are realizing losses in the billions from foreign revenue as a result.

Forex rate risk has become a priority for businesses around the globe. But you might be wondering, “What about my business?” You don’t have to be a Fortune 100 company to protect yourself from currency fluctuations. If your business is affected by Forex (Foreign Exchange) rate risk, it may be easier for smaller firms to take action to protect themselves.

It all starts with hedging.

What Is hedging?

“Hedging one’s bets” is a common phrase that means lowering the risk of a negative outcome of a future event. In the financial realm, hedging is an action to mitigate market risk. Most of us hedge daily without even knowing it’s a hedge. Buying car and home insurance are hedging against a significant loss caused by an accident or fire. Rain in the forecast? Grabbing an umbrella on the way out the door is hedging against getting soaked.

Modern hedging began with agriculture in the 1840s. Chicago was the commercial hub of the Midwest, and farmers brought their grain to the city to sell to merchants. There was inevitably too much wheat during the harvest and not enough in the winter. So prices fluctuated wildly, soaring during the winter and crashing in the summer. The Chicago Board of Trade was created so that grain traders could dampen the seasonal swings and determine future pricing. Over time, the same mechanisms used to smooth grain prices were adapted to the needs of financial markets.

In the financial realm, hedging is an action to mitigate market risk.

Modern Hedging

Hedging products have evolved, but the basic premise has stayed the same. Futures, forwards, options, and swaps are financial tools used to hedge risk. Here are several examples:

How does Southwest Airlines continue to offer low fares while oil prices are soaring? They hedge against the rising cost of fuel.
How does the farmer ensure they stay profitable in light of an uncertain harvest? They enter into contracts with buyers like Kellogg’s to ensure they get an appropriate price for corn ahead of the harvest. The farmer and Kellogg’s represent two sides of the same coin.
How do corporations protect their international revenues from the damaging effects of a rising dollar? They hedge.

Who Needs To Hedge?

Anyone doing business across borders is subject to forex rate volatility—either because of buying foreign goods and services or paying employees overseas. Many assume that market fluctuations are random, so hedging is just as likely to result in a loss as it is to add to profits. The truth is that hedging is more about predictability than profitability.

A hedge may lose money, but you’ll also lock in a price that works for your business. Planning and hedging will keep your business on a course of lower volatility and dampen what could be wild month-to-month swings in revenue and or profits. Hedging means peace of mind and fewer sleepless nights.

Understanding hedging is the first step to lowering your forex risk. Next, you’ll want to learn about the tools and strategies that will help you implement a hedging strategy.