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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.

ByHoang TruongUpdated

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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.

Where it fits
TopicRisk, Return & the CAPMCoreSubjectCorporate FinanceCore

The formula

LaTeX
Vhedged=Vexposure+PayoffhedgeV_{hedged} = V_{exposure} + \text{Payoff}_{hedge}

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

PracticeCORE

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?

Select an answer to check your understanding.