Hedging is a common buzz word in the financial world. Not only on the investment front, but also for the businesses that have any kind of dependency will have to look for hedging against fluctuations in forex prices, either by currency trading or forex hedging.
But what exactly is hedging? How does hedging work? What all financial instruments are required in hedging? In this article, let me give you an example of hedging and the answers to some such similar questions.
In simple words – hedging means eliminating the risk. Also, some financial experts and professors say that risk can never be eliminated, so for them, hedging means eliminating the effects of risk.
Starting the hedging example at the root level:
Let’s say there is a farmer who has harvested his field and is expecting to produce 1 quintal (100 Kgs.) of wheat grain after 3 months. Now, he is planting today for expecting future returns – a typical case of investments. Instead, this is observed in everyday’s life. You work for a month, and then get the salary. A shopkeeper buys products today and sells it later for profit.
However, from the point of view of farmer, there is a big risk. The risk is that if the weather is good then there may be big supply of wheat as most of the farmers will have good crop – so since the supply will be high, the demand will fall and so will the prices fall. Therefore he is at a risk of getting lower prices.
Also, if the weather is bad, then he may not have a good crop. So though there will be big demand due to shortage of supply and hence higher prices, but he will not have sufficient amount of crop to sell.
Ultimately, he is at a risk. So what should he do?
Before going into the solution, let’s take the case of a baker who needs wheat for preparing bread and earn his living by selling the bread he prepares in his bakery.
The baker is running a risk of high price of the wheat, which may be due to bad weather.
So he is at risk.
Both in case of farmer and baker, the risk comes in from the future price fluctuations and uncertainty. For the farmer, it is the low price that he may get for selling his crop, and for the baker, he may have to pay a high price for the wheat which is used as an ingredient to his business.
So, what both of them can do is get into an agreement for the future. The agreement can be something like this:
Let’s say the current price of wheat is $1 PER Kg. The farmer is worried that he will be at a loss if after 3 months when his crop is ready for sale, the price may come down to say, just $0.75 per Kg.
On the other side, the baker is worried that the price of wheat may rise in 3 months time and it may reach higher, say $1.25 per Kg.
Hence, they both meet up and decide to get into an agreement with a certain FUTURE price of wheat, say $1.05. As per the agreement, the farmer will deliver 1 quintal of wheat (100 Kgs.) after 3 months time and the baker will pay to the farmer $105, (100 Kgs. * $ 1.05) the same rate they agreed upon.
So what has happened here? Since the farmer and the baker were worried about the future price movements of the product, they got into an agreement TODAY, so that their FUTURE RISK is covered. Three months down the line, let whatever be the price of wheat, the contract will be honoured by both the farmer and the baker.
Case 1 - Say if after 3 months, the wheat price reaches $2 per Kg, then the baker will be in profit - Because he got into a FUTURE contract with the farmer to buy wheat at $1.05 per Kg. It will be the farmer who will loose on his prospective earnings. However, the farmer will still receive his expected rate of $1.05.
Case 2 - On the other hand, if the wheat price drops to $0.50, then the farmer will be winning – because of his future agreement. The baker will have to buy the wheat from him at $1.05 per Kg rate, though the baker can purchase it for cheap in the open market. Hence, the baker will loose on the current market prices.
But the most important part of such a future contract is that both the parties have to agree to a future price and obviously they will do it only if they are satisfied with it. Hence, in case -1, even if the farmer appears to be on the loosing side with respect to the current market price, he has actually achieved the purpose of eliminating the risk of price fluctuation – He has got the SELL PRICE that he wanted. In case 2, even though the baker appears to be loosing because of paying a higher price than the existing market price, he has achieved the objective of eliminating the risk in buy price – he has got the BUY PRICE that he wanted. This is a typical and most fundamental example of hedging or risk management.
Not only with farmers and bakers, risk management and hedging is something that is practiced all throughout the globe. Intelligent CFO’s and organizations that have businesses split across various countries and revenues in different currencies do go for hedging and risk elimination.
Continue to Part 2: What to look for hedging while buying stocks?
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