Hedging is risk transfer, not prediction
A hedge reduces exposure to a price you do not control by taking an offsetting position. An exporter who will receive dollars in three months can sell those dollars forward today. The rate is now fixed. If the currency moves in the firm's favour, the firm gives up that gain; if it moves against, the loss is capped.
That trade — certainty in exchange for upside — is the whole point. A firm that hedges is not guessing where the market goes. It is deciding which movements it can absorb and which it cannot.
The first question in treasury is never 'what will the rate do?' It is 'what happens to us if it moves 10% and we have done nothing?'
The four instruments
Most corporate hedging is built from a small toolkit. The choice between them is a choice about cost and flexibility.
- Forwards: a private contract to exchange at a fixed rate on a future date. Precise, but illiquid and locked in.
- Futures: standardised forwards traded on an exchange, with daily margin. Liquid, but the contract may not match the exposure exactly.
- Options: the right, not the obligation, to transact at a set price. You pay a premium for the ability to keep the upside.
- Swaps: exchanges of cash-flow streams, most often fixed for floating interest. The workhorse for managing debt.
What firms actually hedge
The exposures that matter are the ones attached to real cash flows. A firm with dollar receivables and taka costs hedges the currency. A firm with floating-rate debt hedges the interest rate. An airline hedges jet fuel because fuel is a cost it cannot pass on instantly. A utility hedges because its customers expect stable prices.
What a firm should not hedge is a risk it can simply pass through, or one it can absorb without harm. Hedging a risk you have already priced into your contracts is paying twice for the same protection.
The cost of a hedge
Hedges are not free, even when there is no premium. An option costs cash up front. A forward costs the opportunity value of the upside you surrendered. Every hedge adds documentation, accounting, and a counterparty. And a hedge that does not move exactly with the exposure leaves basis risk — the residual gap between the instrument and the thing it was meant to protect.
Accounting matters too. Under IFRS 9, a hedge that qualifies for hedge accounting can smooth the earnings effect, but qualification requires evidence that the hedge is effective. A hedge that fails the test can make reported profit more volatile, not less.
A one-line test
Hedge the exposures that are large, uncertain, and outside your control. Leave the rest alone. A firm that hedges everything is not prudent; it is paying a premium to avoid thinking about which risks actually threaten it.
Sources and further reading