What is hedging? A Guide to Hedge Strategies, Risks and Benefits, and How to Get Started
Explanation, strategies and visualization included.
Hedging ABC - what, how and why to hedge?
What is hedging?
Hedging means a way to protect your liabilities or net-liabilities (liabilities less investments).
Hedging is a strategy that helps you to protect your future cash-flows or transactions or debt portfolio from being exposed to potential financial losses when markets move (interest rates, currency rates etc). By using hedging instruments such as OTC derivatives, you can mitigate risks and maintain greater stability in your cash-flows and P&L, even when market conditions are volatile and unpredictable.
While hedging doesn’t guarantee that your liabilities will be immune to losses, it reduces the impact of unfavorable market movements by balancing out the risks with gains in derivative instruments.
Example: In the same way that home insurance guards you from the financial worries of an unexpected accident, hedging shields your liabilities from unexpected market shifts. Best example is switching from floating rate borrowings into fixed rate borrowing by utilizing interest rate swaps.
That´s why hedging is a great way to protect your existing debt or foreign currency transactions, or pre-hedging future currency cashflows or debt renewals.
How does hedging work?
Hedging works by using financial instruments to offset potential losses in liabilities or currency cash-flows, against unfavorable interest rate or currency rate movements.
Businesses use derivate instruments that are negatively correlated with the underlying transaction or cash-flows. This way, if the underlying cash-flows lose value, the hedge can help compensate for that loss.
Currency Risk management: Hedging currency risk in € when doing business US based clients or suppliers.
A German company that exports regularly goods to the USA. The company is concerned that the USD $ may weaken against the €, reducing the payments value quoted in the USD $.
To hedge this risk, the company could enter into forward contract to lock in an exchange rate for the future date (by assuming that the client pays on time). It means, if the company is set to receive $10 million say in 1 month, they can agree to exchange USD for Euros at the fixed rate already now.
If the USD weakens during coming weeks, the forward contract ensures that the company is still getting the budgeted amount of Euros, and separate currency forward contract here is a protection against potential currency fluctuations.
It is very common strategy used by the European businesses for managing currency risk.
So, hedging works by balancing the possible risks and potential rewards across different assets to be more protected against volatility in markets and more precise to forecast the financial outcome for the businesses.
The effectiveness of a hedge depends on the accuracy of hedge ratio and the type of hedging strategy employed
Top 3 Hedging Strategies that companies use to reduce the market risks
Interest Rate Hedging
Interest rate hedging helps protect against the risk that changing interest rates (reference rates) could increase borrowing costs.
Common interest rate hedging techniques:
- Interest Rate Swaps
- Interest rate options
- Interest rate swaptions
Currency Hedging
Currency hedging helps manage the risk posed by fluctuations in foreign exchange rates that can impact cross-border cash-flows and balance sheet positions
Common currency hedging techniques:
- Forward Contracts
- Currency Options
Portfolio Hedging
Portfolio hedging reduces the overall risk of an debt portfolio by adjusting fixed or floating rate loan ratios, or implementing hedge programs to mitigate risk exposure.
Common portfolio hedging techniques:
- Fixed -floating ratio
- Adjusting Hedge ratio with Derivatives
- Portfolio -Swap
Why should small and medium sized businesses use hedging instruments?
Companies hedge to be better prepared for unexpected financial risks that could disrupt their cash-flows or impact profitability.
In an ideal scenario, small and medium sized businesses would simply understand the risk and adapt instantly to market changes. In reality, market shifts are often unpredictable, and it’s challenging for most companies to react without proper foresight in real time.
Hedging offers a way to manage unexpected financial risks before markets move. Heding in advance (often called pre-hedging) gives companies extra time to adjust their funding strategy, cross border payment terms or even business plans if needed. Most businesses find that the stability and protection provided by hedging outweigh the costs.
With hedging, a company can achieve:
Safeguarding Cash-Flows Market Volatility
Hedging reduces companies exposure to sudden market swings, which can protect them during business downturns.
Ensure predictable Financial Planning
Hedging helps companies to have a clear control over future cost and revenues. Therefore the budget forecasting can be more accurate.
Protecting Against Cost Increases
With hedging, companies can avoid the impact of rising costs that could decrease their profit margins.
What are derivatives in hedging?
Hedging is a way used to protect financial liabilities and investments, and derivatives are the OTC financial instruments commonly used in hedging for this purpose.
Derivatives are OTC financial contracts whose value is derived from another price, or interest rate. When used correctly, derivatives can act as a natural offset to the underlying exposure such as currency cash-flows or loan agreements. If the interest rates rise, the derivative can help offset that loss. With lower interest rates (capital markets or swap curve), the derivative may result in a negative value.
Types of Commonly used OTC Derivative instruments
Different derivative products are customizable and usually fall into 3 main categories of derivatives:
#1 Fixing the price or rates
- Advantages of using fixed rate products
- Gives certanty over the market moves
- No cost in advance
- Easy to mark to market in accounting
- Disadvantages of using fixed rate products
- Unwinding a Swap or FX forward earlier can be large liability
- No upside using opportunity
- Needs credit line or in some cases cash-collateral to use
As the name suggests, these derivatives allow companies to lock in a interest or currency rate for the future.
Why? No matter how the market price moves, companies can predict and control their costs, providing stability and certainty for budgeting and financial planning.
Common “fixed rate” derivatives:
- interest rate swaps
- FX forwards
#2 Options
As the name suggests, these derivatives provide options and rights without the obligation to act.
This means that companies can choose whether or not to use them. The key feature that distinguishes these derivatives from others, such as forwards, or swaps (which require action), is the flexibility of “optional” choices.
To use this option, companies need to make an upfront payment, called the “option premium.” While there is a cost for using these “optional” derivatives, they remain affordable or maybe the only hedging strategy for companies with limited creditworthiness or company size.
Why? By paying the premium upfront, companies can protect themselves against rising interest rates or unfavourable currency movements while still having the opportunity to benefit from positive market movements such as lower reference rates or desired currency rat movements.
Common “optionality” derivatives:
- interest rate cap /floor
- fx option
- Advantages of using "Option" products
- certantly over worst-case result
- You can have "upside" participation
- No credit line needed
- Disadvantages of using "Option" products
- Need some cash upfront for premium payment
#3 Combination products
Combination products in hedging involve using multiple derivatives in a single strategy. This approach makes hedging more customizable, allowing companies to create solutions that align with their specific cash-flow or funding profiles, and business models.
Why?
Combination products provide a tailored way to manage risk, helping companies address multiple level risks and opportunities at once.
Common “combination” type derivatives:
- Interest rate collars
- participation swap
- FX Collars
- Advantages of using "Combination" products
- Certaintly to know best and worst scenario
- Allows some fluctuation
- Can be combined without the cost
- Disadvantages of using "Combination" price products
- Having more "upside"hedging and less protection on "downside"
- Can be a liability if unwound at unfavourable market conditions
How to handle headging strategies and techniques with an ease?
Hedging is a great way to manage your company interest rate risks, currency risk and debt portfolios.
BUT… As financial markets can be unpredictable and fluctuate a lot, hedging can also be challenging. Especially since hedging has some costs itself. How ever there are a few things to keep in mind to plan your hedging strategies.
#1 Do not underestimate the hedging cost vs. benefit ratio.
It’s common for treasury managers to focus primarily on hedging direct costs, such as premiums when using options, or transaction costs.
However, it’s equally important to consider hedging indirect costs, such as opportunity costs and market impact costs. These costs might not be immediately visible, but they can still affect the overall efficiency of a hedging strategy. While the main goal of hedging is to reduce risks and potential losses, it’s important to recognize that some costs are acceptable when managing those risks.
To make informed, confident decisions, it’s helpful to model different hedging scenarios. This allows risk managers to strike a balance between minimizing costs and providing robust protection against potential risks.
This version clarifies the meaning and improves flow, making the message easier to understand and more professional.
#2 Use hedging where it really matters
While managing risks through hedging can seem like a tempting solution, it’s important to hedge only when there is a critical impact to a company’s financial health. To use the recourses the best and actually gain the impact in the financial management.
However, hedging is often used in situations where it doesn’t create significant value—neither for the company’s financial position nor for its stakeholders.
To start, it’s essential to understand the status of debt and currency exposure, assess the immediate and future impact of market moves on company’s P&L and cash-position. By understanding clearly these risks, businesses can identify the right events in which hedging can provide the most value, helping to minimize losses and maximize potential gains.
#2 Use treasury risk management system that simplifies your daily work
Hedging involves many variables, from various products to changing market conditions. Relying solely on static spreadsheets, commonly used by CFO offices, makes it difficult—if not impossible—to create optimal hedging strategies.
Instead, consider using easy-to-use software that requires no integration and provides up to date market data. Such tools allow you to spot risks early and effortlessly simulate different hedging scenarios with a few clicks.
This approach not only saves time but also helps prevent losses and enables you to make more informed decisions.
You can try TreasuryView out for 30 days, no credit card, no software to install.
Example: How to hedge future debt exposures?
See how the right financial risk management tool can:
- simplify your tasks in hedging future loan exposure,
- increase your confidence in decision-making in regarding funding and hedging strategy,
- and allow you to navigate different scenarios with ease.
See more derivateives examples:
Get started with the dashboard that ease your hedging strategy and helps to forecast future scenarios.
Know your data is accurate and up-to-date—always.
Get started with the dashboard that ease your hedging strategy and helps to forecast future scenarios.
Know your data is accurate and up-to-date—always.