Hedging, in terms of corporate finance, means to offset risk – often risks that cannot be insured against or budgeted for.
The most common risks where hedging can be an effective tool are:
- Interest rates moving – It costs more to borrow, or savings bring in a lower rate of return
- Adverse currency movements – exports are worth less or imports cost more
- Rising raw materials costs – a poor crop or a natural/man-made disaster reduces the quantity on the market, or rising demand from other users pushes up the price
How does hedging work?
In financial markets, much hedging is done using derivatives. Be aware that hedging has its critics – particularly the use of financial derivatives as a hedging tool. Some see derivative products as a threat to market stability.
Much of this mistrust stems from the financial crisis of 2008, when a sharp downturn in the US housing market led to a collapse in derivative products linked to US mortgages.
Here, we'll ignore these criticisms and focus on the types of derivative used as tools to hedge against the three risks identified above.
Hedging against interest rate risk
To keep things simple, let’s imagine that a company called DeltaCorp must, in a year, repay a loan of £1m plus a fixed rate of interest of 1.7%.
Now let's say Sigma Group has a similar sized loan and is paying a floating rate of interest, based on six-month LIBOR at 0.5% plus 1%.
Sigma believes that over the next year interest rates will rise, and would like to limit its exposure to this risk.
Delta believes the interest rate environment is benign and it is willing to take a risk that by entering into an interest rate swap with Sigma, the overall annual rate it pays will be lower than the 1.7% it is already liable for.
Delta must still pay its initial lender the 1.7% fixed rate interest on its loan (£17,000), and Sigma must still pay the current floating rate of 0.5% + 1% (£15,000) to its original lender.
But, under the terms of the swap, Delta effectively owes Sigma £15,000, while Sigma owes Delta £17,000. This is partially offset, and so Sigma pays Delta the difference of £2,000.
Now let’s say Sigma’s prediction was right and rates did go up over the year, and the floating rate averaged 0.9% + 1%.
Both parties paid their interest obligations to their initial lenders, but under the terms of the swap agreement, Delta now owes Sigma the new floating rate amount of £19,000, while Sigma still owes Delta £17,000 – a net £2,000 to Sigma.
Sigma successfully hedged its exposure to the rising rate. It still had to pay that higher rate of 0.9% + 1% = £19,000, but received £2,000 under the terms of the swap from Delta. A total interest payment of £17,000 – the same as the 1.7% fixed rate.
Interest rate swaps are customised contracts – the specifications agreed between the two counterparties – but can be an effective way of cutting out the risk of falling interest rates.
The danger is that if the floating rate you pay to your counterparty rises significantly above the flat rate being paid to you, you're on the wrong end of the deal and lose out.
Hedging against currency risk
When companies operate abroad and then repatriate foreign earnings back into their domestic currency, they do so at the risk of currency movements that could adversely affect their profits.