Definition: The Hedging is a financial technique that helps to reduce or mitigate the effects of measurable type of risk from the future changes in the fair value of commodities, cash flows, securities, currencies, assets and liabilities. It is a kind of an insurance that do not eliminate the risk completely but mitigate its effect.
In other words, it is a risk-reducing tool wherein the firm uses the derivatives and other instruments to offset the future changes in the value of securities, currencies, assets, etc.
The firm uses several derivatives or other instruments to hedge against the exchange rate risk. These are:
- Risk Hedging with Forward Contracts
- Risk Hedging with Future Contracts
- Risk Hedging with Swaps
- Risk Hedging with Option Contracts
- Risk Hedging with Insurance
The following are the main advantages of risk management through hedging:
- The financial risk management helps the firm to increase its debt capacity. Through risk management, the firm is able to understand the types of financial risks associated with its investments that helps an organization in the minimization of the cost of financial distress.
- The financial risk management enables the managers to hedge against the probable movements in the exchange rates and interest rates. These are the factors that are beyond management’s control and cannot be predicted with certainty. Thus, it encourages the managers to direct their efforts towards the improvement of the operations rather than worrying about the factors that are not under their control.
- It helps to differentiate between the effects of fluctuation in the external factors Viz. Exchange rates and interest rates and the management’s performance. Even if the company hedges its risk and suffers a huge loss, then it can be said that the management is bad.
Thus, the primary objective of this risk management tool is to reduce the risk, not to save cost or earn profits.