What is Hedging

Hedging is a strategy applied to minimize risk. It also involves the synthetic insurance, i.e., the implementation of a dynamic trading strategy that determines the lower bound on the value of a position. Market participants in the 18th century realized the importance of avoiding uncertainty and created futures markets for certain agricultural commodities. The first futures clearing system that set the foundation for modern futures markets was authorized by Tokugawa Yoshi-mune, the 8th shogun of the Tokugawa era, in the Dojima District of Osaka, Japan, in 1730. The only traded commodity was rice and speculations were welcomed by the shogunate in order to support the rice price during deflation. In addition, the Dojima rice market was setting the trading standards for all of Japan. In modern financial markets, participants hedge in a multitude of both financial and real assets for various reasons such as taxes, bankruptcy and financial distress costs, managerial contracting with information asymmetry as well as the lack of diversification faced by large ownership blockholders.
Following an increase in market volatility in the last quarter of the 20th century, firms were exposed to new hedging requirements. With the breakup of the Bretton Woods system in the 1970s currency market volatility increased, which has created additional problems for both exporters and importers in planning the cost structure throughout the fiscal year. If imported goods/services are to be paid with foreign currency, the value of which is expected to decline after the expiration of the trade credit period, the exporter cannot determine with certainty what will be the exchange rate and thus the total income in domestic currency. Vice versa, importers will not be able to determine the cost in domestic currency for the payment to be made at a future date to foreign trade partners. This exposure can be hedged with the use of forward contracts that will determine the future exchange rate at which foreign currency can be bought (for the importer) or sold (for the exporter). The impending future cost will be known today, but the company is not protected against any foreign exchange movements that could benefit them, such as the higher (lower) future spot rates for exporting firms (importing firms).
This dilemma could be addressed by balancing assets and liabilities in currencies that have high positive correlations. The so-called exposure netting is routinely applied by multinational corporations’ (MNCs’) treasury departments and provides substantial cost savings. The Swiss franc, Swedish krone, and euro have high positive correlations, and generally demonstrate negative co-movements vis-a-vis the U.S. dollar and some Asian currencies that closely track it (e.g., the Malaysian ringgit or Hong Kong dollar).
Another effective response is the use of call or put options due to their attractive feature of providing the right, but not the obligation, to be exercised in the future. If a call option is in the money, the importer will buy foreign currency at a lower price, and the total cost will increase by a premium paid for the call option. The exporting firm will exercise a put option and sell foreign currency at a higher-than-prevailing exchange rate. The total benefits will be reduced by a premium initially paid for the put option. Third, an exporter expected to sell foreign currency at a future date can borrow foreign currency and convert it immediately into domestic currency. The total amount can be freely used for other investment purposes, because the debt will be paid on the due date after the receipt of the foreign currency. Importantly, the future principal and interest payments must equal the amount of foreign currency to be received. By contrast, importers will purchase foreign currency and invest it at a market rate until the prospective purchase date. Therefore, the final payment for imported goods will be executed without the involvement of any future forex transactions. Fourth, companies may decide not to hedge if they expect that foreign exchange rate movements will be beneficial to them. Finally, companies can request payments in their own currencies, which is a strategy routinely applied in countries with internationally traded hard currencies.
Oil shocks in the 1970s and financial deregulation in the 1980s associated with a strong globalization drive in the 1990s were characterized by market instability and interest rate swings. Market participants can lock in a short-term interest rate by entering a forward forward contract or a forward rate agreement. The forward forward contract comprises the borrowing and lending of the same sum of money over unequal time periods. The interest rate differential and the length of the net investment horizon will determine the interest rate payment. In the forward rate agreement, the interest rate is determined for a notional amount of principal.
Innovations
As part of the drive to increase returns to shareholders and adequately address the newly created market environment, financial institutions have created a whole stream of new financial innovations. Unfortunately, companies sometimes think of derivatives as a source of extra income, instead of a risk-reducing vehicle that could lead to significant losses. In addition, hedging can provide market participants with protection against downside risk, but prevent them from profiting if new market opportunities have been created. Therefore, the risk management team has to carefully plan whether or not it is justifiable to apply a hedging strategy If so, the frequency of adjustments in instruments used to hedge the underlying instrument should be determined. This process is called dynamic hedging and determines the success of a company’s risk management. Too-frequent changes impose a cost burden, while their infrequency leads to discrepancies that could ultimately result in unexpected losses.