We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.
Finance

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

What Are the Different Types of Hedging Tools?

By Naomi Smith
Updated: May 16, 2024
Views: 36,939
Share

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.

Share
SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Discussion Comments
By Ocelot60 — On Dec 26, 2014

I had a discussion with my financial planner last year about risk management tools. I was pleasantly surprised at how open he was to the discussion, and how knowledgeable he was about tools that would help my financial situation.

By Rundocuri — On Dec 25, 2014

Though understanding investing and finance can be complicated, knowing about tools that reduce risk is important for many investors. A good financial adviser will explain concepts like hedging tools to clients so the can make the best decisions with their money. Anyone who has not had this discussion with his or her financial adviser should have a discussion about risk.

Share
https://www.smartcapitalmind.com/what-are-the-different-types-of-hedging-tools.htm
Copy this link
SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.