Hedging Strategies
Hedging is a risk management strategy designed to reduce or offset price risks. It involves the use of market instruments such as futures, options and averages and is done to reduce risk as opposed to increase profits. There are many types of financial risk that can be protected against with a hedge including risks involving commodities, credit, currency, interest rates and volume among others. Hedging can be used to help produce consistent and stable cash flows, lessen transaction costs and to reduce risk exposure. Essentially, when operating in futures markets hedging implies taking a position opposite to that in the physical market.
Hedging can vary in complexity from relatively simple “offsetting trades” to complex derivative structures. An example of hedging is a Canadian company that has sold a product to a customer in Japan. The payment which is due is 60 days will be made in Japanese Yen. The Canadian company is concerned about fluctuating exchange rates so they enter into a forward contract to lock in the exchange rate 60 days from now, as a hedge against foreign exchange exposure. In this way the Canadian company protects themselves against loss should exchange rates take an unfavorable turn.
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