A company that imports raw materials, borrows at a variable rate, or conducts operations in multiple currencies can see its costs fluctuate greatly depending on financial markets.
These fluctuations can squeeze margins and make results more difficult to forecast. To limit the impact of these fluctuations, companies and investors have a range of hedging tools.
Protecting against financial risk
Hedging tools refer to the set of instruments and strategies that reduce an economic actor’s exposure to an unfavorable variation in a price, an interest rate, an exchange rate, or another financial asset.
Hedging does not therefore aim necessarily to realize a gain, but to make a cost, a revenue or a future value more predictable.
A Tunisian company that must pay in a few months an invoice denominated in euros can, for example, seek to protect itself against a rise in the euro relative to the dinar. Similarly, a company indebted at a variable rate may want to limit the risk related to a rise in interest rates.
Instruments tailored to each risk
Futures contracts (forwards or futures) allow, in particular, to lock in in advance the price at which a future transaction will be realized. They can be used to hedge exchange-rate, interest-rate, or commodity risks.
Options give their holder the right, but not the obligation, to buy or sell an asset at a predetermined price. They thus allow protection against an unfavorable evolution while preserving the possibility to benefit from a favorable evolution, in exchange for the option premium.
Swaps, for their part, allow the exchange of certain cash flows. An interest-rate swap can notably permit transforming a variable-rate exposure into a fixed-rate exposure, according to the contract terms.
A hedge that has a cost
Hedging against a risk does not necessarily eliminate all potential losses. The instruments used can have a cost, especially in the case of options, and their effectiveness depends on the quality of the hedging strategy.
There is also hedging risk when the movement of the instrument used does not perfectly match that of the risk the company seeks to neutralize. Excessive hedging can also prevent a company from taking advantage of favorable market movements.
Hedging tools form an important element of the financial management of companies exposed to market fluctuations. Their main aim is to reduce uncertainty and to protect margins or cash flows against adverse movements. When used well, they can thus transform part of a market risk that is difficult to manage into a more predictable financial exposure.
