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Using an offsetting financial position to reduce a particular price or other financial exposure, rather than eliminate every business risk.
Save conceptHedging means arranging an offsetting position to reduce a particular financial risk. A company expecting to pay a supplier in a foreign may want protection against that becoming more expensive. It can use a contract designed to offset the resulting cost increase. The intended relationship to an existing exposure distinguishes the hedge from a position taken simply to profit from a price prediction.
The business first identifies the payment or asset at risk, its amount and its timing. It then selects a contract whose payments move in a way that offsets the chosen exposure. A forward may fix an exchange price for a future purchase. Other contracts work differently. Protection is strongest when the , amount and timing match; a mismatch can leave some of the original risk uncovered.
In a hypothetical example, an importer must pay US$10,000 in three months and agrees to buy those dollars at 90 rupees per dollar. The contracted rupee cost is 900,000 rupees. If the later market rate is 95, the same dollars would cost 950,000 rupees without that agreed exchange price. The contract protects the specified price, assuming its terms are fulfilled; fees and other costs are excluded from this example.
The importer may also forgo a cheaper purchase if the market rate moves in its favour. Hedging therefore does not mean obtaining the best eventual price. It reduces a defined uncertainty. A hedge also cannot remove every risk, such as a supplier failing to deliver goods or the other party failing to honour a contract. Documentation must identify the rather than assume every is automatically a hedge.
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