What it means
Hedging means taking a position that moves in the opposite direction to an existing risk, so that gains on one offset losses on the other. In a micro-hedge, the matching is one to one.
A company with a payment due in a foreign currency, for instance, takes a forward contract for that exact amount and date. The advantage is precision.
The terms of the hedging instrument, such as amount, date and underlying price, are chosen to mirror those of the item being protected. That makes it clear whether the hedge is working, and makes it easier to qualify for hedge accounting.
Hedge accounting is a set of rules that allow the gains and losses on the hedge to be recorded in the same period as the gains and losses on the hedged item. Without it, the hedge could create volatility in reported profit even when it removes economic risk.
A micro-hedge with clear documentation links usually meets the conditions more readily than a broad portfolio hedge. The disadvantage is cost and effort.
A business with hundreds of exposures would need hundreds of separate contracts, each with its own fees and paperwork. Many firms therefore use micro-hedges for large, important exposures, and macro-hedges for the rest.
There are limits to precision. If the instrument and the exposure are not identical, for example a futures contract on a similar but different grade of a commodity, a basis risk remains.
A hedge can also reduce upside: a business that locks in a price cannot benefit if the market moves in its favour.
In practice
Real-world examples.
Example
An exporter will receive $2,000,000 from a customer in 90 days, but its costs are in another currency. It enters a forward contract to sell the dollars at a fixed rate on the settlement date. The exposure is specific, so the hedge matches it exactly.
Example
A company with a $10,000,000 floating-rate loan buys an interest rate swap on the same amount and term. The swap fixes its interest cost for the life of the loan. The treasury team documents the link between the swap and the loan for hedge accounting.
Example
An airline buys fuel call options to cover a specific quantity of jet fuel it expects to burn next quarter. If the fuel price jumps, the options pay out and offset the extra cost. If the price falls, the airline loses only the premium paid.
Formula
Calculation
Hedged outcome = Result on the underlying exposure + Gain or loss on the hedge
Suppose a food manufacturer will buy 50,000 bushels of wheat in three months and fears a price rise, so it buys futures at $6.00 a bushel. Three months later, the spot price is $7.00. The wheat costs 50,000 x 7.00 = $350,000, which is $50,000 more than at $6.00. The futures gain = (7.00 - 6.00) x 50,000 = $50,000. Net cost = 350,000 - 50,000 = $300,000, which is 50,000 x 6.00. If the price had fallen to $5.00, the wheat would cost $250,000, and that saving would be cancelled by a futures loss of $50,000, again giving $300,000.Case study
Seen in the real world.
Dunmore Foods is an illustrative, fictional manufacturer of breakfast cereals with a contract to buy 100,000 bushels of oats in four months for a fixed-price product launch. The finance director was worried about a price spike, because the launch margin was thin.
The company bought futures covering exactly the volume and delivery month at $4.00 a bushel, giving a target cost of $400,000. At delivery, the oat price had risen to $4.60, so the oats cost $460,000, but the futures contract paid out 0.60 x 100,000 = $60,000, bringing the net cost back to $400,000.
The launch margin held as planned. The illustrative lesson is that a micro-hedge works best when the instrument closely mirrors the exposure, and that the benefit is certainty, not extra profit.
Watch out
Common mistakes.
- Assuming a hedge makes money, when its purpose is to reduce risk and it will often show a loss on one leg.
- Hedging an amount larger than the exposure, which turns part of the position into speculation.
- Skipping the documentation needed for hedge accounting, which can cause the hedge to add volatility to reported profit.
Questions
People also ask.
What is the difference between a micro-hedge and a macro-hedge?
A micro-hedge protects one identified item, while a macro-hedge protects the net risk across a whole portfolio or balance sheet.
What is basis risk?
It is the risk that the hedging instrument and the exposure do not move in perfect step, so some of the risk remains even after hedging.
Can a micro-hedge be cancelled early?
Usually yes, but closing the position may cost money, depending on how the market has moved since the contract was made.
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