Hedging is defined as an investment intended to lower the risk of negative price movements in an asset. In business, hedging is typically used to protect a business from major negative changes in the cost of raw materials. Essentially, hedging is a tool that can help businesses minimise or negate costly changes to input prices.
The Simplest form of Hedge
In its most simple form a hedge involves the purchase of insurance against future events. In our personal lives we use home insurance to hedge against the risk of our house burning down, amongst other things. Of course, nobody expects their house to burn down, but there is a risk it could happen, so to protect ourselves from this we pay a premium to have home insurance as a hedge against this risk.
In a business context the simplest form of hedge might be done by taking out a futures contract. An airline, for example, might want to hedge against changes in the price of fuel. To do this the airline might make a hedge to buy fuel at a set price in the future, avoiding the risk that political unrest in the middle east (for example) could significantly drive up fuel prices in the intervening period.
The business would obviously have to pay to take out this hedge against future price rises. If however, the price of fuel fell during this period, then yes, the hedge has been unnecessarily purchased, however, the fall in the fuel price may mean the business is on the whole paying no more than when the futures contract was purchased.
Ultimately, and I hope you can see this from the above example, hedging is about bringing stability to a business. This stability can be defined as the ability for a business to maintain its margins regardless of whether the price of a raw material moves up or down.
Under certain circumstances it may not make sense for a business to use hedging, even if it depends on a raw material whose price is volatile. If a business has a very strong financial position then it may be more profitable under all but the most extreme of circumstances to ride out this price volatility and save money by avoiding the cost of purchasing numerous hedges.
In its simplest form you can think of hedging as insurance against the risk of future events occurring, thus bringing stability to a business. The example provided above is very simple. There are of course many different reasons why a company may wish to use hedging including to protect itself against business foreign exchange fluctuations. There are also many different ways to hedge, including forward exchange contracts for currencies, pairs trading, futures contracts for interest, and money market operations for currencies, to name just a few.
* Image by Living Walls Instant Hedges