Hedging

Hedging is a technique which individuals and companies use to protect themselves from risk in financial transactions.

There are different methods and instruments used to hedge different positions depending on the nature of the original position and the original financial instrument.

Example

Soccerica is company operating in Soccerasia and is engaged in manufacture of high quality footballs. The company delivered an order worth 100,000 Euros on 1 December 2012 to a European customer. The European company is expected to pay Soccerica by 31 December 2012. The spot exchange rate between Soca (the Soccerasia currency) and Euro is 5 Socas per Euro. The 1 month future exchange rate is 4.9 Socas per Euro. Soccerica expects the exchange rate to fluctuate a lot so on 1 December 2011, it entered into a future contract to sell 100,000 Euros at 4.9 Soca per Euro on 31 December 2012.

By entering in this future transaction, Soccerica has effectively locked itself at 4.9 Socas per Euro and it will neither suffer from any adverse exchange movements nor gain from any favorable exchange movements. On 1 December 2012, it will receive 100,000 Euros and convert them at 4.9 Socas per Euro to get 490,000 Socas.

Written by Obaidullah Jan