Companies often try to protect their assets from various risks in a process known as hedging. Think of hedging as being similar to buying auto insurance. When you're out driving your car, there is a risk that you could get into an accident and cause costly damage to other drivers' property. In order to prevent that risk from harming you financially, you buy an insurance policy that will cover any damage you might cause. This is the main idea of a hedge.
There are two sides to a hedge -- the hedged item and the hedging instrument. The hedged item is what creates the risk for the company. In our previous analogy, the car is the hedged item. Companies have many items that expose them to risk -- such as interest rates, foreign exchange rates, the value of investments, and prices of necessary supplies.
The hedging instrument is designed to mitigate that risk -- which is the purpose of your auto insurance policy. Companies use hedging instruments known as derivatives in order to help cover potential losses. These are contracts whose value is designed to move in the opposite direction of that of the hedged item. Futures contracts and stock options are examples of well-known hedging instruments.
For example, if a company needs to buy large quantities of gasoline to sustain its business activities, it could be smart risk management to hedge against an unexpected rise in gasoline prices.
Cash flow hedges
A cash flow hedge is designed to minimize the risk that a company will have to pay more than it expects. The gasoline example in the previous section is an example of a cash flow hedge.
As a more concrete example, let's say that your company will need to buy 1000 tons of copper next year, which sells for $4,585 per ton as of this writing. So you expect an expense of $4,585,000 for your copper needs, and you use this figure when planning your budget. If the price of copper spikes to $6,000 per ton between now and next year, this would mean more than $1.4 million in unanticipated expenses.
To mitigate this risk, you could buy some copper futures contracts, which would increase in value if the price of copper were to rise.
Fair value hedges
On the other hand, a fair value hedge is a type of hedging instrument designed to limit exposure to changes in the value of an asset or liability. For example, if your company owns a large stock portfolio, you could buy put options on the stocks in the portfolio. And, the value of these options would increase if the stock's price were to fall, reducing or even eliminating your potential losses.
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