Hedging is a technique to reduce exposure to measurable types of risk in financial market transactions. It is a type of insurance, and while it cannot eliminate risk completely, hedging can mitigate the effect. The correct hedging tools will depend on the types of assets or transactions involved. For example, for a portfolio containing international investments, it would be prudent to hedge against unexpected currency movements, in order to preserve the value of the portfolio in the home currency. The main types of hedging tools include futures, options, and forwards — whether on one of the underlying assets in the portfolio, in a currency index, or an asset negatively correlated with the portfolio.
Futures are an agreement to purchase a product or currency, on a specific date at a specific price. Options are a more flexible hedging tool. A company or investor can purchase a 'call' option, which is the right to buy an asset at a particular price, or a 'put' option, to sell at a particular price at a future date. Unlike futures, the option owner is not required to follow through with the transaction if the market price is more advantageous than the option price.
Hedging currency risk can be done with forward contracts, futures, or options. For a company with international operations, the use of currency hedging tools is very important when converting foreign operation profits into the home currency, or purchasing inputs or equipment overseas. Forward contracts are unique to the foreign exchange market, and allow a company or investor to lock in a specific transaction to exchange one currency for another on a particular date.
Unlike futures contracts, a currency forward contract is not standardized or tradeable, and if one party defaults, the other party is completely out of luck. Futures contracts represent a less risky alternative to hedging against currency market fluctuations. Depending on the direction and the amount of volatility in the currency market, the company will choose futures or options — or a mix of both — depending on the specific currencies involved.
A money market hedge is another type of hedging tool for a future foreign currency transaction. For instance, if a French company wants to sell equipment to Japan, it can borrow in yen now, and pay the yen-denominated debt when the Japanese company pays for the products. This allows the French company to lock in the current exchange rate between the Euro and the yen. The cost is the interest rate on the yen loan, which is may be lower than the cost of another hedging tool.
One common use of futures as a hedging tool is when a company depends on a certain commodity to produce its products, such as coffee beans. To protect itself against adverse movements in the price of the coffee beans, the company may choose to purchase coffee futures, and lock in a particular price. The company is required to make the purchase, even if the market price of coffee is lower than the contracted price. This is a risk to using futures as a hedging tool, unless the cost of the price uncertainty is greater than the cost of paying above market price and where possible, options present a more flexible hedging solution.
All hedging tools and techniques involve several costs. The first is the cost of the hedging instrument itself. The second in the risk and associated cost if the choice of hedging instrument results in higher than market costs of the underlying asset. Therefore, the use of hedging tools reduces both the total risk and return of the underlying asset or business. For corporations, however, the value of hedging against currency or commodity market fluctuations is in eliminating uncertainty. This can allow for smooth operations and the ability to keep prices consistent, which may far outweigh the cost of the hedging strategy.