A hedge is an investment that you make in order to manage your risk. When you hedge, you’re minimising or offsetting the possibility you’ll lose money should things go wrong – hedges protect growing crops from being trampled by intruders and swept by the wind. You’re also limiting any potential losses to a known amount – hedges are often used to clearly delimit gardens and fields.
The idea of hedging to limit risks and losses is akin to getting personal insurance for your health, your home, your car: for a fee, you can know and limit your exposure to future events.
In the domain of finance, including the foreign currency markets, people hedge their investments using two main techniques:
Diversification is when you invest in several different assets instead of putting all your money in a single investment.
As the name suggests, this spreads your risk by ensuring you don’t have all your eggs in one basket. The idea is that several different assets are unlikely to all fall in value at the same time. So, if one of your investments goes bad, the others will make up for it.
In foreign currency trading, you can diversify by holding money in several different currencies. This way, if the exchange rate of one of your currencies becomes unfavourable, you can exchange another.
Imagine you had £5,000, $5,000, and €5,000. A supplier in Switzerland sends you an invoice for fr.1,000. You don’t have any Swiss Francs in the bank, so you need to exchange some money.
The CHF/GBP exchange rate isn’t very good at the moment. The CHF/USD exchange rate is better, but still unfavourable. But the CHF/EUR exchange rate is very good.
If you only held money in British Pounds or Dollars, you’d have to settle for exchanging at an unfavourable rate. Luckily, you’ve diversified, so you can exchange your Euro and get more bang for your buck.
By the same token, if the CHF/EUR exchange rate goes down, you could exchange US Dollars or British Pounds to get a better deal.
Derivatives are financial contracts that get their value from an underlying asset. In foreign exchange transactions, the underlying asset is typically a currency’s exchange rate.
You can use derivatives to hedge against unfavourable exchange rates in two main ways:
- To lock in a better exchange rate. So, if an invoice in a foreign currency is due two months from now, for instance, you have the peace of mind of knowing exactly how much it’ll cost you, regardless of currency fluctuations
- To get cheaper foreign debt. You can do this using a type of derivative called a swap. Imagine you’re a British business that wanted to set up shop in the US, but you can’t get a loan from a US bank. You could enter into an agreement with a US business that wants to set up shop in the UK and has the same issue. The US business would take a loan out from a US bank, you’d take out a loan from a UK bank, and you’d swap. This way, both of you would get a better rate.
- Hedging has negative connotations, mainly because of hedge funds and their high profile role in the 2008 financial crisis. But the truth is that most of us have hedged at some point in our life. While the term “hedge” is only used to refer to a certain type of investment, a home insurance policy, for instance, is technically a type of hedge, because it protects you from the financial risk of your home getting damaged.
- An astounding number of businesses have little or no protection at all against their currency exposure. Various studies indicate that approximately 70 to 80 percent of SMEs that sell or buy goods and services abroad have never hedged themselves against their currency exposure.
- Hedging as we know it today started in the 19th century. Farmers selling grain at the Chicago Board of Trade came up with the idea of dealers committing to buy a certain amount of grain in the future at a pre-agreed price. This commitment allowed them to plan the year’s production in advance and make better budgets and forecasts. Grain, sugar, coffee, and other crops are still hedged on a daily basis today.
- While modern hedging started in the 19th century, the term “hedge” is much older. The English poet John Donne talked about ‘hedging debts’ in his letters to Sir Henry Goodyere dated 1620. A few decades later, in his satirical 1672 play The Rehearsal, the 2nd Duke of Buckingham George Villiers introduced the idea of taking out a series of small bets in order to be able to cover a larger bet. And the phrase “hedging your bets” was born.
Want to know more?
- This article has a good, in-depth overview of hedging, including the different techniques you can use and the risks involved.
- So what do hedge funds actually do, and how are they different from the actual technique of hedging? This article reveals all in simple, straightforward language.
“Just as you wouldn’t put all your money in one stock or investment, you shouldn’t rely on a single currency being stable if you trade internationally. Currency fluctuations are a fact of life and they affect businesses of all shapes and sizes. Hedging is a relatively inexpensive and risk-free way to make sure your business is protected if foreign exchange markets don’t go your way.”