A hedging strategy is a risk management strategy to avoid large financial statement losses due to investment fluctuations. Hedges work like an insurance policy, offsetting potential losses with gains from other investments. It’s common for a business to take out an insurance policy for weather damage. Although you can’t control nature, you can minimize financial losses if a bad storm were to cause damage.
Let’s say that your company does business with other countries. As a result, you are now exposed to currency risk if your customer’s currency appreciates or depreciates. Reducing your risk of currency losses can be done by solidifying a forward contract with an investment dealer to purchase currency for a specified price on a certain date. This reduces your risk of realizing losses.
Even if your business doesn’t deal with international currencies, you might still have hedging strategies in place. If your investment portfolio has risky investments, like startup companies, you might offset a portion of this risk with term bonds or money market account investments. Hedging strategies can take on many different goals, like the elimination of market volatility and currency exposure. Regardless of the type of hedging strategy you deploy, the primary goal is to manage financial risks.
Derivatives are contracts with prices dependent on the value of an underlying asset. There are many different types of derivatives, including futures, forward contracts, and options. A call option gives your business the right to buy an asset, while a put option offers you the opportunity to sell an asset.
The price of the hedging derivative depends on the downside risk of the underlying asset. The lower the downside risk, the lower the cost of the hedge. However, the higher the price, the more expensive the put option will be, resulting in more price protection. The variables of derivatives and put options can be altered to create hedging instruments within your budget and protection levels.
The hedging strategies that work best for your organization depend on your goals and business activities. Let’s go through some of the common hedging strategies.
This hedging strategy uses futures contracts. Futures contracts are an agreement to buy or sell an asset for a specific price at a future date. The goal of futures contracts is to minimize the losses realized with price fluctuations.
Pair trading involves opening a long position and a short position on a similar asset. The price difference between the two assets looks to reduce market volatility and preserve gains.
Currency hedging is a popular strategy for companies that engage in global business. Currencies can fluctuate, especially in relation to each other. For example, the value of a customer’s currency can change from the date of the invoice to the date of payment. Instead of your company recognizing the loss associated with this situation, you can take out a currency hedge to preserve your income.
Arbitrage is a strategy that involves buying an item and selling it on the same day at a higher price. This hedging strategy aims to increase gains with short-term sales to offset other losses. Arbitrage is similar to spread hedging, where your business buys a put option at a high price and sells another at a lower price, both with the same date.
Hedging offers a variety of benefits, outside of preserving losses. Let’s explore some of these advantages in more detail.
One of the top benefits of an effective hedging strategy is risk management. By limiting your losses from market movements, you are able to reduce your exposure to volatility. This can result in more informed financial decisions and a better overall financial position.
Diversification is the process of selecting investments in different asset classes, companies, and sectors. Diversification reduces the downside risk associated with market movements. For example, if your currency exposure skyrockets, but you have other investments to balance out the swings, you will be able to minimize downside risk.
Another main advantage of hedging is the ability to limit losses. Reporting negative average annual returns can put you in a tough position with shareholders, lenders, and other third parties. After all, these individuals want to see financial stability, not consistent losses. Deploying an effective hedge strategy increases the likelihood of reporting gains.
Effective hedging strategies give you the ability to enter and exit markets with ease. If the market starts to trend downward, you can easily sell off your short and long positions to safeguard your gains. Flexibility in the decisions of your business is crucial to maximize profits.
When you take out positions that look to reduce losses, you are giving your business the opportunity to enhance your returns. For example, if your currency hedge eliminates a $10,000 loss, your financial statements will reflect $10,000 more of income. With no hedging strategy in place, your business would be forced to report $10,000 less in profit.
Many business owners are hesitant to expand due to currency risk. With price certainty on your financial commitments, you have full transparency in the money your business will receive from the transaction. This allows you to solidify expansion efforts with customers outside of your home country.
Hedging strategies do come with risks. For one, hedging isn’t free. Your business will incur broker and contract charges regardless of whether your hedge is successful. These fees can add up and impact your profitability. Hedging also requires you to follow hedge accounting policies.
In addition, there’s no guarantee that your hedge will be effective. For example, if you enter into a contract expecting foreign currency rates to increase, but they actually decrease, your hedge is ineffective. Although most contracts give you the option of going through with the hedge, you will still be required to pay contract fees, adding to potential losses.
Another risk associated with hedging is limited gains. If an investment you are hedging against increases in value, you could be limiting your gain. Let’s say you enter into a contract to buy $100 U.S. dollars for $70 AUD in two months. If the U.S. dollar were to depreciate to 10%, you could be locked into the contract for $70 AUD for $100 U.S. dollars, resulting in overpayment.
Every business will have a slightly different hedging strategy. This makes it important to evaluate your existing processes to find strategies to improve effectiveness, accuracy, and efficiency. Let’s go through the steps to create your hedging strategy.
The first step in crafting your hedging strategy is to outline your goals. What are you trying to accomplish with hedging? Are you looking to minimize your losses? How about reducing currency risk and managing market volatility? Uncovering the root of your goals will help you choose the right hedging instruments.
Next, you need to determine what assets you are hedging for in your business. Are you looking to hedge your accounts receivable against currency volatility? What about stock market investments or material purchases? Make a list of your transactions that could benefit from hedging.
What strategies will you use to hedge? Are you looking into put or call options? How about diversification or arbitration? For each of the assets you identified in Step #2, choose a hedging instrument. It’s not uncommon to have multiple hedging instruments for each asset class. Write down all strategies that might apply.
Now, it’s time to implement your hedges. This might involve purchasing offsetting assets or setting up contracts. Be sure you keep your goals in mind throughout the process. You don’t want to lose focus of your overall hedging strategy.
On a regular basis, you need to revisit your hedges to gauge progress. Are your hedges performing effectively? Do you need to go in a different direction? Consistent oversight of hedges is important to optimize efficiency and effectiveness. You might find that a hedging strategy that once worked is no longer a viable option. Don’t be afraid to adjust your hedges to realign your actions with your goals.
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