What it means
Every business carries exposures it did not choose: an airline is exposed to jet fuel prices, an exporter to exchange rates, a borrower to interest rates. A hedging transaction is a second, offsetting trade taken purely to reduce that exposure, usually through a forward contract, a futures contract, an option or a swap.
The defining feature is that the hedge is linked to a real underlying position. Buying oil futures because you think oil will rise is speculation; buying them because you will need to purchase 500,000 litres of fuel next quarter is hedging, even though the trade itself looks identical.
Hedges are rarely perfect, and the leftover risk has a name. Basis risk is the gap between the thing you are exposed to and the instrument you hedged with, and it appears when a jet fuel buyer hedges with crude oil futures because no liquid jet fuel contract is available at that size.
Companies also choose how much of an exposure to cover, expressed as a hedge ratio. Covering 100% removes the uncertainty but also removes any benefit if prices move in your favour, so many treasury policies hedge a declining proportion of exposures further into the future, for example 80% of the next quarter and 40% of the quarter after.
Accounting adds a further layer. Under hedge accounting rules, a company that can document the link between the hedge and the underlying exposure may report both in the same period, which stops the income statement swinging wildly just because a hedge is marked to market before the exposure it protects has occurred.
In practice
Real-world examples.
Example
A coffee roaster with fixed-price supermarket contracts for the next year buys coffee futures covering 70% of its expected bean purchases. When bean prices jump 30%, the futures gain offsets most of the higher purchase cost and the roaster's margin holds.
Example
A property developer borrowing $12,000,000 at a floating rate enters an interest rate swap, paying a fixed 5.4% and receiving the floating rate. Rates then rise, but the developer's effective cost stays at 5.4% and the project budget remains intact.
Example
A UK software firm billing American clients in dollars sells dollars forward each month as invoices are issued. The finance director accepts that this gives up any windfall from a strengthening dollar in exchange for knowing the sterling value of revenue in advance.
Formula
Calculation
The result of a hedge is measured as: Net outcome = Outcome on the underlying exposure + Gain or loss on the hedging instrument, with Hedge ratio = Amount hedged / Total exposure.
A US manufacturer expects to receive EUR 5,000,000 from a European customer in six months. At today's rate of $1.10 per euro that is worth $5,500,000. Treasury policy allows an 80% hedge, so the company sells EUR 4,000,000 forward at $1.10, a hedge ratio of 4,000,000 / 5,000,000 = 80%.
Six months later the euro has fallen to $1.02. The customer's payment converts to 5,000,000 x $1.02 = $5,100,000, a shortfall of $400,000 against the original expectation. The forward contract gains 4,000,000 x ($1.10 - $1.02) = $320,000.
Adding the two together gives $5,100,000 + $320,000 = $5,420,000. The company still lost $5,500,000 - $5,420,000 = $80,000, which is exactly the 20% of the exposure it chose to leave unhedged. The hedging transaction removed four fifths of the currency risk.Case study
Seen in the real world.
Consider Harborline Freight, an illustrative and fictional regional trucking company that burns about 4,000,000 litres of diesel a year. After a year in which fuel costs rose 35% and destroyed its operating margin, the board asks the finance team to hedge.
The team hedges 60% of expected diesel volume using futures, leaving 40% floating so the company still benefits if prices fall. In the following year diesel prices rise again and the futures position gains $520,000, offsetting most of the increase in the physical fuel bill and keeping operating profit within 4% of budget.
The instructive twist in this fictional case is what happens next. Prices then fall sharply, the hedge loses money, and an operations manager complains that the company "wasted" money on hedging. The finance director explains that a hedge that loses when prices fall is working exactly as designed, because the point was a stable fuel cost, not a cheap one.
Watch out
Common mistakes.
- Judging a hedge by whether the hedging instrument made money, rather than by whether the combined position was more stable than the exposure alone.
- Over-hedging by covering more than the actual exposure, which converts a risk-reduction trade into a speculative bet in the opposite direction.
- Assuming a hedge removes all risk, when basis risk, timing mismatches and counterparty risk usually leave some exposure behind.
Questions
People also ask.
Is hedging the same as insurance?
It is similar in purpose, but an option-based hedge is closest to insurance because you pay a premium, while a forward or futures hedge gives up upside instead of paying a premium.
Should a small business hedge its currency exposure?
Only if the exposure is large enough to threaten profitability, since hedging carries administrative cost and margin requirements that can outweigh the benefit on small amounts.
What is hedge accounting?
It is a set of accounting rules that lets a company match the reported timing of a hedge with the exposure it protects, avoiding artificial swings in reported profit.
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