Hedging
Hedging means taking a position, often using a forward, future or option, that offsets an existing exposure so a loss on the underlying is matched by a gain on the hedge, reducing risk rather than seeking profit.
See it move
An exporter due $200,000 in 90 days sells the dollars forward at €0.92, locking in receipts of €184,000. If the spot rate falls to €0.85, the unhedged receipt would be only €170,000. The forward hedge is worth €184,000 − €170,000 = €14,000 more than leaving the exposure unhedged.
The formula
Variables
- Combined value after hedging (€)
- Value of the unhedged underlying exposure (€)
- Gain or loss on the hedge instrument (€)
A hedge is effective when its payoff moves opposite to the exposure, keeping the combined outcome close to the value locked in when the hedge was set up.
Check yourself
A bakery expects to buy 20,000 kg of wheat in three months and, worried about rising prices, buys a forward contract locking in a price of €0.42 per kg. At the delivery date the market price has risen to €0.55 per kg. What does the bakery actually pay for its wheat, and how much did the hedge save it compared with buying at the market price?