Tuesday September 26, 2017 - 10:29:50 GMT
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The beginnerís lowdown on hedging
It's a phrase that crops up umpteen times in day-to-day life - and this even applies to the Average Joe. However, if you were to question people on what hedging really meant, you'd probably be greeted with several blank looks.
In the financial world, it's a crucial piece of the industry. Without it, companies would be severely lacking when things did start to go downhill, and this is one of the reasons why financial hedging solutions are in such high in demand.
Following on from the above, why exactly is hedging so important for businesses? Here, we'll answer some of the most common questions around the subject.
What is hedging?
If we were to describe hedging in one sentence, it would be the process of safeguarding against worst case scenarios. It's a little like insurance; companies will pay a bit extra to obtain some sort of protection if things do start to go wrong.
When we talk about "going wrong", it naturally relates to the financial markets. These can change and companies don't have any control over it. With hedging, they are at least protected if these changes are going to hurt them.
Why would companies choose to hedge?
We touched on the why-factor in the previous section, but let's delve into further details. When we spoke about the financial markets changing, we were referring to the likes of interest rates, the price of oil, equity prices and foreign exchange rates. All of these can move up and down significantly - and impact many businesses along the way.
Let's take a couple of examples. The first is a candy manufacturer. These companies use a lot of sugar and suffice to say, this is a commodity. If the price of sugar happens to increase, their business model is going to be effected.
Then, there is foreign exchange. This is a much bigger matter and there have been some examples of companies losing huge sums of money due to fluctuations in currency. Considering that around $5 trillion is traded every single day - this last sentence should come as no surprise. If a company buys in one currency and sells in another, any changes in the foreign exchange rate can be crushing (or rewarding, on the other side of the coin).
What methods do they use?
There's no one-fits-all answer here, the approach will vary depending on what is being safeguarded. Some companies might opt to agree a forward contract - meaning that the price is always fixed. Alternatively, some might sway towards a call, which can be likened highly to an insurance policy and means that the company is limited in some ways if things do start to slide badly.
In terms of the cost, it's once again a situation of there not being a direct answer. This is going to be based on countless factors, with the size of the risk being the primary one. As we alluded to at the start of the article, this is the reason why companies specializing in risk management are so sought after nowadays.
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