What it means
Hedging means taking a second position, often in a derivative such as a futures contract, that moves in the opposite direction to something you already own or owe. If the two positions offset each other exactly, the hedge is perfect and the value of the combined position stays the same whatever the market does.
A farmer who owns wheat and sells wheat futures is the classic picture. In reality a perfect hedge needs several things to line up.
The hedging instrument must be tied to the same asset, in the same quantity, for the same period and delivered at the same place. Even small differences leave residual risk, called basis risk, which is the gap between the price of the thing hedged and the price of the instrument.
The point of a perfect hedge is certainty, and certainty has a price. By removing the risk of loss the business also removes the chance of gain, and the hedge itself has costs such as premiums, commissions and margin requirements.
For this reason managers usually choose a partial hedge that reduces most of the risk at a lower cost. Perfect hedges are most realistic when the exposure and the instrument are almost identical, for example a company that owes a fixed amount of a foreign currency on a known date and buys a forward contract for exactly that amount and date.
Even then the counterparty could fail to perform, which is a risk that remains. The nuance is that "perfect" refers to the offset, not to the quality of the decision.
A perfect hedge can still be a bad decision if the cost was high or if the underlying exposure disappears, as when the farmer's crop fails and the futures position is left uncovered.
In practice
Real-world examples.
Example
An airline agrees to buy 1,000,000 gallons of jet fuel in six months. It buys a fuel forward contract for the same quantity and date, so whatever happens to the market price its cost is fixed.
Example
An importer owes a supplier $750,000 payable in 90 days in a foreign currency. Its bank sells it a forward contract for exactly that amount and date, locking the dollar cost and removing exchange rate risk.
Example
A jewellery maker holds gold inventory and sells matching gold futures. When the gold price drops, the gain on the futures offsets the fall in the value of the inventory almost exactly, although small differences in quality or delivery date leave a little risk.
Formula
Calculation
Hedge ratio = size of the hedging position / size of the exposure
Net result = gain or loss on the asset + gain or loss on the hedge
Suppose a farmer holds 50,000 bushels of wheat worth $6.00 a bushel and sells 10 futures contracts of 5,000 bushels each, which covers 10 x 5,000 = 50,000 bushels. The hedge ratio is 50,000 / 50,000 = 1. If the price falls to $5.20, the stored wheat loses 50,000 x 0.80 = $40,000. The futures position gains 50,000 x 0.80 = $40,000. The net result is -40,000 + 40,000 = $0, so the hedge is perfect.Case study
Seen in the real world.
Northgate Bakeries is an illustrative, fictional company that buys 400 tonnes of flour a quarter. The finance director wanted to remove the price risk for the next three months and asked her bank for a hedge that matched the flour contract in quantity and delivery date.
The bank offered a forward contract for 400 tonnes at $500 a tonne, fixing the cost at 400 x 500 = $200,000. When the market price later rose to $560, the company still paid $200,000 for the flour under the forward, while the spot cost would have been 400 x 560 = $224,000, a saving of $24,000.
Had the price fallen to $450 the company would have paid more than the market, a cost of 400 x 50 = $20,000. The illustrative lesson is that a perfect hedge buys certainty, and the company gives up the chance of a better price in exchange.
Watch out
Common mistakes.
- Believing a perfect hedge is easy to achieve, when differences in timing, quantity, quality and location usually leave some residual risk.
- Assuming a hedge makes money, when its purpose is to fix an outcome and it also removes potential gains.
- Forgetting the cost and counterparty risk of the hedge itself, such as fees, margin calls and the chance the other party fails.
Questions
People also ask.
Do companies usually aim for a perfect hedge?
Not always, because a perfect hedge can be costly or unavailable, and many firms hedge only part of the exposure to keep flexibility.
What is basis risk?
It is the risk that the price of the hedging instrument and the price of the thing being hedged do not move together exactly, which leaves part of the exposure uncovered.
How do you measure how good a hedge is?
Analysts compare the changes in value of the hedge and the exposure, and a ratio close to one means the hedge is very effective.
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