Hedging

What it means

Hedging means taking a position that moves the opposite way to the risk the company carries. For currency that is usually a forward: an agreed rate for a future date whatever the market does.

The aim is not to make money. The aim is that the costing of a contract still holds six months later when payment arrives, and that the result is driven by the business rather than the exchange rate.

Besides the forward there is the option: a right, not an obligation, to deal at an agreed rate. It protects against an adverse move while leaving the company the gain from a favourable one, but it costs a premium paid up front, much like insurance, and that hits cash flow at once. A forward only looks free because its price is built into the agreed rate.

How it works in practice

Only what is certain gets hedged: a signed contract, a planned import, loan instalments in a foreign currency. Hedging more than the company will actually receive is speculation, not protection.

It is not free in the books: revaluing the derivative runs through profit and, with exchange differences, can swing. A currency account and a natural hedge cover part of the risk more cheaply.

Before the first forward the bank asks for a framework agreement on financial market transactions and a questionnaire on the company’s experience with investment instruments. It may also want collateral that ties up cash in the account for the life of the deal. That has to be allowed for when planning liquidity, especially if several contracts are hedged at once.

What to watch out for

The worst case is hedging a deal that never happens. The forward stays alive and settles in cash, although the revenue it was meant to protect never arrived.

For a derivative to be accounted for as a hedge, the hedge has to be documented from the start and its effectiveness shown. Without that the forward is treated as held for trading and its fair value at the balance sheet date goes straight to profit or loss, so the company may report a derivative loss in a year when the hedged deal has not even happened.